Why Do Companies Go Public?

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Investors prefer that companies use IPO proceeds strategically, as opposed to funding large compensation packages for management.
Investors prefer that companies use IPO proceeds strategically, as opposed to funding large compensation packages for management. (Image: denphumi/iStock/Getty Images)

A company’s initial public offering is the first time it is able to issue common stock to investors, generally through registered investment advisers and via large stock exchanges such as the Nasdaq and New York Stock Exchange. Stock sales can vary dramatically in size, but the primary benefit of "going public" is the ability to exchange stock for cash and subsequently use that cash to fund growth. The amount of stock offered depends on a company’s optimal capital structure, which is the mix of debt and equity financing.

Generate Proceeds

Raising cash via stock issuances is a way for companies to raise cash while incurring relatively low up-front costs. The actual cost of equity depends on a variety of factors, but is generally more of an opportunity cost than a direct cost for the company. Once cash is raised, it can be used for a variety of purposes, such as paying down debt, distributing cash to shareholders or more practical uses. For example, a restaurant company can fund the opening of new locations and marketing campaigns. Companies can use cash for making strategic acquisitions, such as buying competitors or, in the case of mining companies, purchasing mineral rights to explore for more ore or precious metals.

Credibility

Although not an absolute requirement, going public can bring a company a certain amount of credibility with investors. This is partially due to the public company disclosure requirements. Companies registered with the Securities and Exchange Commission must file quarterly and annual audited financial statements. Also, investors view a stock exchange listing as a tacit endorsement by the exchange, which – especially today – are highly sophisticated investors in their own rights.

Liquidity

Achieving liquidity for a company’s common stock is an important component of issuing stock options, which are often key to finding and retaining a talented workforce. This is particularly true for many technology companies, which issue stock options to employees, setting the expectation of a big payday when the company goes public. Also, enhancing the liquidity of a common stock increases its underlying value by lowering liquidity risk. Finally, as a company grows, SEC rules require companies with more than 500 shareholders to register as public companies. The basis for this regulation is that a wide shareholder base should not be subject to excess liquidity risk, which can affect other companies, such as other industry members or investors.

Research suggests that companies use IPO proceeds more for re-optimizing capital structure, as opposed to funding growth and investment.
Research suggests that companies use IPO proceeds more for re-optimizing capital structure, as opposed to funding growth and investment. (Image: fotoyy/iStock/Getty Images)

Exit Strategy

It can be important for a fast-growing company to go public when market conditions are optimal. For example, one of the factors driving the Facebook IPO during 2012 was pressure exerted upon Mark Zuckerberg by shareholders and investment bankers. Zuckerberg was rightly concerned that if the market became less receptive to social media companies, the company might not be able to raise the desired amount of funds, effectively devaluing the company. Another major motivation for company founders is the need for an exit strategy and the ability to achieve a liquidity event that generates huge profits for the company’s founders. These profits are associated largely with the extra liquidity associated with being a publicly traded company, and because of them, corporate executives often greatly anticipate a company’s IPO.

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