IPO Advantages and Disadvantages

An initial public offering (IPO) seems to be the de facto goal of many startup companies Founders, investors, and public observers often wonder, “When will this company IPO?”, “What will this company’s stock price be when they eventually IPO?”, and “Why hasn’t this company completed an IPO yet?” You may have been asked some of these questions about your own company. While an IPO is a worthy objective with many potential benefits, there are also many risks and disadvantages associated with going public, and thus, an IPO may not be suitable for every company. Although many people believe that every successful company is public, there are many private companies that are also thriving, such as Dell, Cargill, and Koch Industries.

This article will discuss the advantages and disadvantages that you should consider when you are thinking about an initial public offering.

Advantages

Fundraising

The most often cited advantage of an initial public offering is money. In 2016, the median proceeds received from an initial public offering were $94.5 million, and many offerings bring in hundreds of millions of dollars. For example, in 2016, the largest IPO—ZTO Express—netted $1.4 billion. The proceeds from an IPO provide ample justification for many companies to go public even without looking at the other benefits, especially considering the many investment opportunities available because of the new capital. These funds can benefit a growing company in countless ways. Companies may use an initial public offering to finance research and development, hire new employees, build buildings, reduce debt, fund capital expenditure, acquire new technology or other companies, or to bankroll any number of other possibilities. The money provided by an IPO is significant, and can transform the growth trajectory of a company.

Exit opportunity

Every company has stakeholders who have contributed significant amounts of time, money, and resources with the hopes of creating a successful company. These founders and investors often go for years without seeing any significant financial return on their contributions. An initial public offering is a significant exit opportunity for stakeholders, whereby they can potentially receive massive amounts of money, or, at the very least, liquefy the capital they currently have tied up in the company. As stated in the previous paragraph, initial public offerings often raise nearly $100 million (or even more), which makes them very attractive to founders and investors who often feel that it is time to receive financial compensation for years of “sweat equity1.” It is, however, important to note that in order for founders and investors to receive liquidity from an IPO, they will have to sell their shares of the now-public company on a secondary exchange2 (e.g., New York Stock Exchange). Shareholders do not immediately receive liquidity from the proceeds of an IPO.

Publicity and credibility

If a company hopes to continue to grow, it will need increased exposure to potential customers who know about and trust its products; an IPO can provide this exposure as it thrusts a company into the public spotlight. Analysts around the world report on every initial public offering in order to help their clients know whether to invest, and many news agencies bring attention to different companies that are going public. Not only do companies receive a great deal of attention when they decide to go public, but they also receive credibility. To complete an offering, a company must go through intense scrutiny to ensure what they are reporting about themselves is correct. This scrutiny, combined with many individuals’ tendencies to trust public companies more, can lead to increased credibility for a company and its products.

Reduced overall cost of capital

A major obstacle for any company, but especially younger private companies, is their cost of capital. Before an IPO, companies often have to pay higher interest rates to receive loans from banks or give up ownership to receive funds from investors. An IPO can lessen the difficulty of receiving additional capital significantly. Before a company can even begin its formal IPO preparation process, it must be audited according to PCAOB3 standards; this audit is normally more scrutinizing than any prior audits, and fosters greater confidence that what a company is reporting is accurate. This increased assurance will likely result in lower interest rates on loans received from banks, as the company is perceived as being less risky. On top of lower interest rates, once a company is public, it can raise additional capital through subsequent offerings on the stock exchange, which is usually easier than raising capital through a private funding round.

Stock as a means of payment

Being a public company also allows for the use of publicly traded stock as a means of payment. While a private company has the ability to use its stock as a form of payment, private stock is only valuable if a favorable exit4 opportunity arises. Public stock, on the other hand, is essentially a form of currency that can be bought and sold at a market price at any moment, which can be helpful when compensating employees and acquiring other businesses. For a company to thrive, it must hire the right employees. The ability to pay employees with stock or offer stock options allows a company to be competitive when trying to hire top-tier talent, even if the base monetary salary is lower than what competitors are offering. Additionally, acquisitions are often an important way for companies to continue to grow and stay relevant. However, acquiring other companies is normally very expensive. When a company is public, it has the option to issue shares of its stock as a means of payment, rather than using millions of dollars of cash.

Disadvantages

Additional regulatory requirements and disclosures

Unlike private companies, public companies are required to file their financial statements with the Securities and Exchange Commission (SEC) every year. These financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles and audited by a certified public accounting firm. These SEC regulations are both burdensome and costly. Reporting a company’s financial position publicly requires that company to establish more stringent financial controls, staff a financial reporting team and audit committee, implement quarterly and yearly financial close processes, hire an audit firm, and complete hundreds of other tasks. These responsibilities cost public companies millions of dollars every year and require thousands of labor hours. For more information about public company audits see our article Audit prep for the Big Leagues.

Market pressures

Market pressures can be very difficult for company leadership who are used to doing what they feel is best for the company. Founders tend to have a long-term view, with a vision of what their company will look like years from the present and how it will impact the world. The stock market, on the other hand, has a very short-term, profit-driven view. Once a company is public, its every move is scrutinized by investors and analysts around the world, who are generally interested in one question: “Will this company meet its quarterly earnings target?” If a company meets its target, its stock price will normally increase; if not, its stock price will normally decrease. Even if leadership is doing what is best for the company in the long-run, failing to meet the public’s short-term goals may cause the company to lose value and the leadership might be replaced as a result. Founders who do not like the idea of being constrained by short-term public goals should think carefully about going public.

Potential loss of control

One major disadvantage of an IPO is founders may lose control of their company. While there are ways to ensure founders retain the majority of the decision-making power in the company, once a company is public, the leadership needs to keep the public happy, even if other shareholders do not have voting power. Going public means receiving considerable amounts of money from public shareholders. Since shareholders have given the company so much money, they expect the company to act in their best interest, even if it means going in a direction the founders dislike. If shareholders feel the company is not operating in a way that will help them make money, they will force the company, through shareholder votes or public criticism, to appoint new leadership.

Transaction costs

Initial public offerings are expensive. Beyond the recurring expenses of public company regulatory compliance, the IPO transaction process comes at a hefty cost. The largest cost of a public offering is underwriter5 fees. Underwriters will typically charge between 5% and 7% of the gross proceeds, which means the underwriter’s discount can cost up to $7 million on an average IPO. On top of underwriter fees, companies who raise an average amount of proceeds (approx. $100 million) should expect to spend about $1.5 – 2 million in legal fees, $1 million on auditor fees, and $500,000 on registration and printing fees. The transaction costs will be even higher if a company chooses to hire a financial reporting advisor6, or other specialty groups. See our article on the costs of going public for more information.

Conclusion

An initial public offering may or may not be the right direction for your company. IPOs come with a host of advantages and disadvantages. While this article highlights many of the common pros and cons of an IPO, it is not comprehensive. If you are considering an IPO, be careful to weigh all of the advantages and disadvantages, be patient, and consider all of your alternatives. For more information on these alternatives, read our Alternatives to an IPO article.

 


 

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Footnotes

  1. The effort a founder or employee has put into a company that has resulted in an increase in the company’s value.
  2. A market place for investors to buy and sell shares of company stock, such as the NYSE or NASDAQ. It is called a “secondary” exchange because it is a where stock is sold after it is initially sold by the company.
  3. Public Company Accounting Oversight Board.
  4. A significant financing event that allows a startup’s early-stage investors to liquidate their holdings and receive a return on their investment. Common exits for startup companies include an acquisition or an initial public offering.
  5. The investment bank that purchases the shares of the company going public and then sells those shares to primary investors.
  6. A consultant, typically an accounting firm, that specializes in drafting and filing statements with the SEC and provides technical accounting support.
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Author Morgan Hunsaker

Morgan grew up in Tokyo, Japan, and has also lived in Thailand, Hong Kong, and Provo, Utah. When Morgan is not studying accounting he can be found playing or watching sports. He is a lifelong Utah Jazz fan and watches at least one Jazz game every week.

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