Part I
Why Go Public?
When a company “goes public” through an “initial public offering” (or IPO), it essentially sells some of its shares to retail and institutional investors, and those shares are then invariably listed on a public stock exchange, where the price for the shares floats up or down depending on a range of factors related both to the financial performance of the company and the state of the capital markets (and the broader economy) more generally. In order to become public, the company must go through a rigorous process of information disclosure centered around an extensive, written prospectus. Then, once public, it must adhere to a range of rules on timely legal and financial disclosure. Why would a business owner agree to jump through all these hoops?
Well, many do not! Particularly in the Canadian tech sector, many owners and managers of entrepreneurial businesses have a good long look at the costs and benefits of going public or staying private, and choose the latter. For example in the US, there are some significant private tech companies, such as SAS.
Moreover, if the owners of a private company want liquidity (that is, they want to turn the shares they hold in their private tech company into money), they can always sell the company outright to an interested buyer rather than sell a part of the company to public investors. And this is still the most common way shareholders of, for example, private Canadian tech companies achieve liquidity — by selling to typically non-Canadian-based larger public tech companies, such as IBM (though, usefully, companies like Constellation Software and Aastra Technologies are now acquirers as well). Indeed, there is by no means any shame in such an exit, particularly given that the founding entrepreneur of the sold company (and often several of his or her senior management), tends to reinvest much of the proceeds of their sale into new, start-up ventures (and the virtuous company cycle of establish, build, grow and sell will begin again).
Accessing Growth Capital
Minting Your Own Currency
This same survey found that 15 per cent of those questioned indicated that their main reason for going public was to be able to use the resulting public stock as a “currency” for acquisitions. That is, as a public company, you can buy other companies and exchange their shares for shares of your own company (or you can make it a combination of shares and cash — or, for that matter, all cash).
Accordingly, if you put together these two categories of respondents to the survey, fully 84 per cent of companies going public in 2007 (at least in the US), did so for financial reasons, and indirectly in order to grow the business. The same dynamics should hold true in Canada (and perhaps even more so in light of the recent credit crisis when access to private capital has been limited).
A Delayed Payday
There are several other good reasons companies go public. The survey noted above found that 31 per cent of senior executives wanted to do so in order that they, other managers who hold shares, and principal shareholders would be able to make some money by selling some (but not all) of their shares upon or soon after the IPO.
This is not surprising. A founder of a company, for instance, may have the bulk of his or her net worth tied up in the shares of his or her company. As a private company, there is no ready market for these shares. Now, of course, the founder could sell the whole company outright (as noted above). But the founder may believe that the company is unfairly undervalued, given the rather early state of development of the company (that is, it’s not a bad business, but “the best has yet to come”). The founder would be well-advised not to sell all of his or her shares at this premature juncture.
This is where an IPO might make good sense. Upon the IPO, the founder either sells very few — or none at all — of the founder’s shares, but waits until a market has truly evolved in the now-public company shares. Presumably the valuation of the company increases as the true potential of the company is realized. Then, from time to time, the founder can sell some shares, all the while working hard to increase the value of his or her remaining shares (the founder may also be subject to restricts on the sale of shares post-IPO imposed by either investment bankers or regulatory authorities, who will want to give the founder an incentive to unlock value).
In a similar vein, other employees of the public company can begin to cash out some of their shares once the company is public and there is a liquid market for the shares. Equally, the company can better recruit staff as a public company assuming they have a stock option plan or other equity based compensation plan of some sort that allows employees to purchase shares of the public company on some favourable basis.
Prestigious Public Companies
One reason popularly perceived as a very important one for going public is “publicity and prestige”; it is often thought, for example, that people would much rather work for a widely known public tech company, than for a relatively (or completely unknown) small, private one. In the event, however, the survey noted above found that only nine per cent of respondents cited publicity and prestige as the main drivers behind going public.
This is an extremely interesting insight (if indeed it is accurate). It tells us that, actually, fairly few founders and other shareholders are motivated principally by what others think, when it comes to the all-important “Go — No Go” decision on the IPO. Rather, the urge to build good companies through growth is the prime driver behind taking tech (and other) companies public. And this is how it should be.
So, assuming you are ready to go public (for all the right reasons), we will look at the legal process involved in doing so in the next edition of the TLQ.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Part II
This is the second in a series of articles about taking a company public. “Going public” is the process of issuing shares to the public pursuant to a prospectus or through a reverse take-over or other process that results in significant disclosure about the financial and other aspects of the company.
Having previously discussed some reasons that private entrepreneurial companies might want to go public, we turn to consider some of the downsides of being a public company. Founders and shareholders of private companies should consider the cons as well as the pros of being a public company, before deciding whether to proceed with an initial public offering (IPO) or other transaction that results in the company being public.
Losing Control
In many private companies, the founder (or founders) of the company is still the principal shareholder. As such, the founder more or less runs the company however he or she likes. For instance, the founder may choose to focus on long-term prospects and make investments that depress cash flow and earnings in the short term, but that increase the chances for longer-term growth and profitability.
By contrast, the management of a public company must maintain close attention on fairly short quarterly time horizons (in addition to meeting long-term expectations). Most public company investors focus on quarterly earnings. For public companies, closing business at the end of each quarter (and at fiscal year-ends) then becomes an extremely important exercise so earnings estimates can be met or exceeded. If quarterly results do not match expectations, many investors will often sell the stock, putting downward pressure on a public company’s share price.
Thus, a founder who takes public a previously private company may well come to feel that he or she has lost control of its destiny, and that as a public company, the requirements of the stock market have taken over. Some founders believe this is a trade-off worth making. Other founders, particularly in knowledge-based industries, leave the public company and start over again with another start up.
Another dynamic of the public company that can give a sense of a loss of control is, as the name suggests, the lack of confidentiality for public companies. In the next article, we’ll see just how revealing the company’s prospectus is (as it should be, in a securities law context). And then all the material information in the prospectus and other disclosure documents is periodically updated so that the investing public can keep tabs on the company. This all makes perfect sense. It’s just that some entrepreneurs are not ready for it, and their expectations around loss of control have to be managed.
A founder’s sense of loss of control can be mitigated somewhat if the company has obtained private equity financing while it was still a private company. In that case, the founder will have had representatives of the investors on the company’s board of directors, and would have provided investors with regular financial information. As a result, founders who have gone through one or two rounds of private equity or other institutional investment tend to find the transition to a public company easier than those who have not done so.
Toward Board Independence
Another way a founder can lose control of a previously private company after it has gone public is through the board of directors. In a private company controlled by the founder, he or she essentially appoints all the members of the board, who serve at his or her pleasure (unless the private company had some private equity or institutional investors, as noted).
With a public company, best practices (and, in some jurisdictions, the law) dictate that a certain percentage of the board members must be independent; that is, connections to the company or the founder that would compromise members’ independence must be limited. Moreover, the agencies that regulate public companies (securities regulators and stock exchanges) are advocating corporate governance practices that include ensuring the majority of directors on a public company board are independent. This allows the board to oversee the management team, and often, to challenge management on fundamental strategies and tactical issues confronting the company.
Independent Board Committees
If most public company boards comprise a majority of independent directors, the audit committee of the board must, by law, solely comprise independent directors. The audit committee members of the board oversee the company’s interactions with its external auditors. They also oversee the internal financial controls of the company, as well as its risk-management procedures. Similarly, the board’s compensation committee comprises either entirely independent directors, or at least a majority of them.
Again, the upshot for the founder is that his or her discretion in both the longer-term strategic and shorter-term tactical decisions for the company will be increasingly narrowed as a result of this additional layer of regulation. The objective is now to achieve better corporate decisions through independent analysis and input. Nonetheless, the result for the founder is less room to maneuver.
Unwanted Sale of the Company
In many cases, subject to any statutorily or contractually imposed escrow requirements, within a year or two of going public, the founder will want to sell some shares of the company. This typically means the founder has done well financially by virtue of the IPO, but it does raise the spectra of the founder eventually losing ownership control of the company altogether.
This is so because once the shareholdings of the founder fall below a certain percentage, the company is susceptible to a take-over bid from another company or one or more investors. In such cases, the buyers usually only have to convince the holders of a majority of the company’s shares to sell into their offer, and they can then become the new owners. Many founders have been ousted from the companies they founded and took public, much to their dismay. But that possibility goes with the territory when the founder takes the company public.
A Public Company Candidate?
Even before considering the issues surrounding control — and the concerns the founder might have about losing it — one must ask if the company is even a good candidate for the public markets. As noted, steady quarter-to-quarter earnings performance is vastly important in the public securities markets. Therefore, companies with healthy sales and even robust growth — two requirements for public company success — might still be problematic if their sales, on a quarterly basis, are lumpy or cyclical. A couple of bad quarters can greatly devalue the company’s share price and cause a significant decline in the net worth of the founder (assuming much of it is tied up in shares of the company). And it can take years for the share price to recover.
Another issue revolves around the senior management team required for a public company. In a private entrepreneurial company, the founder may have superior skills and may be the enterprise’s knowledge guru. And as a private company, this may still be the critical skill set of the management team. But in a public company, a CEO’s ability to generate and hold the confidence of the investor community is probably of paramount importance. Thus, many sensible founders change their public titles following the IPO and bring in seasoned senior management — such as a new CEO and CFO — to take the public company to the next level. Many founders that have not followed this path have not done so well — and have devalued their companies as a result.
Once the founder has thought through the various issues noted above, and the decision is made to go public, then the exercise turns to the nuts and bolts of the public offering process.
Often, however (and over the past few years with somewhat greater frequency than in the previous five years), Canadian entrepreneurs do not want to sell their companies, but rather want to stick around and build them. Moreover, they want to grow their companies, either by hiring additional staff with which to undertake the development or selling of new products or services, or by acquiring other companies with complementary or related products (in the tech industry, for example, the Constellation and Aastra Technologies models).
For an entrepreneurial business to either expand its current capabilities or buy a competitor, it requires serious investment dollars. Which brings us to perhaps the leading reason for a company going public — namely, to increase its access to capital. In a 2007 American survey of CEOs and CFOs of US companies (both tech and other) that had recently gone public, more than two-thirds (69 per cent) said their prime rationale for the IPO was to access capital (presumably at rates that were more favorable than the alternatives).
