What is a Public Company?

Overview:

Snapchat goes Public. IPO. That Hot New Public Company Everyone is Taking About.

Purpose:

The purpose of this article is to give some background on what it means for a company to “go public”. We will give a little background on what exactly it means for a company to “go public” and also a little background on the rules and regulations around being a public company.

Assumptions:

We’ll use our MFC Company and we will walk through the process to make them a public company. MFC will want to have their shares listed on the New York Stock Exchange and would really like to sell a million shares at an initial price of $20 per share, so that would give use $20,000,000 of cash to grow our company.

Analysis # 1:

MFC decides it wants to go public because they would like to receive additional cash to help it grow. MFC could have decided to take on debt to get cash but that would require full repayment as defined in a debt agreement. Selling ownership of your company (through selling of shares) doesn’t require repayment, however it does change the ownership structure.  Now that Company MFC has decided it wants to sell its shares, there’s a bunch of work to do before the cash inflow comes through to MFC.

Let’s walk through the step by step process of taking a company public:

You, as the owner of MFC, will need to decide how you would like for the new ownership structure to look like. You will need to decide how many shares you would to offer for sale. By having someone else buy these shares, whoever purchases these shares would now be owners of MFC with you and your percentage of ownership will decrease from 100%.

MFC can also decide what rights come with owning these shares. You might have read that a company is issuing Class A, Class B, non-voting, etc. shares. Facebook is a classic example of a company that issued shares that are different, as described by Fortune magazine, “Currently, Facebook has a dual-class stock structure, with Class A shares having one vote per share and Class B shares, which its founder Mark Zuckerberg and company insiders own, conferring 10 votes per share.”[1]

MFC will then need to go out and hire an underwriter or investment bank to help the shares be listed. MFC and the investment bank will lay out timeline and fees in an engagement letter. Together they will draft a prospectus document with which will include audited financial statements, description of the company and the management team. The SEC will review the prospectus as to whether the company is allowed to list and sell their shares in the public market.

While the prospectus is being reviewed by the SEC, the investment bank will go on a road show in order to drive up interest for the stock and try to find potential buyers for the stock when it goes on sale in the public markets.  The company and the investment bank can enter into 3 different types of agreement in selling their stock:

  • Firm Commitment – means the investment bank will purchase all the available shares from the company and resell those shares to the public;
  • Best Efforts Commitment – the investment bank will do its best to sell the shares to the public, but does not guarantees that all shares will be sold; and
  • Syndicate of Underwriters – when multiple investment banks come in to purchase the shares from the company and then resell those shares to the public. [2]

After the road show and final approval from the SEC, the investment bank and company need to decide the date to go public. The day before the initial public offering (“IPO”), the initial price is calculated. The goal of this price is to match supply and demand for MFC: the highest price for which all shares of stock will be sold. The investment bank will pay the company for those shares and will “offer” and sell those shares to on the secondary market [New York Stock Exchange would be an example of the secondary market] the following day.

On the IPO day, the shares will be now sold through the secondary market by the investment bank. For the most part MFC no longer has a direct relationship with the share price. When investors buy or sell shares after the IPO, MFC receives no additional cash from those sales. [In the benefits and drawback section, we’ll talk a little more about how price and number of sales might still affect the company, but for the most part once an IPO is done, the company is not affected by the shares trading on the secondary market.]

Analysis # 2:

Now that you have a timeline of all the work that goes into being a public company, lets look at the benefits and drawbacks of being a public company.

Benefits of Being a Public Company

  • For shares to be sold to the public, a company must file with the SEC. The SEC does allow some exceptions as documented on their website.[3] The number of investors and the dollar value of share sold is limited under the exempt offerings. Thus, for a company that would like to have significant cash from selling their shares, the company will need to register and file with the SEC;
  • There will be some brand building and awareness being built by having your name be mentioned in any number of investment publications and documents;
  • Ability to issue shares of stock to employees for employment incentives;
  • Ability to easily define price to drive and incentive the company’s managers;
  • If a stock issuing is successful, the company can issue more stock and thus receive additional cash inflow;
  • The bond and debt markets may use share price calculations, including market capitalization, to assist in determining lending and interest rates; and
  • Ability to push accounting controls down to all levels of management and have greater accountability over those controls.

Drawback of a Public Company

  • Significant costs fees in underwriting process (investment banks are not cheap);
  • Significant costs to have quarterly reviews and yearly audited financial statements (audit firms are not cheap);
  • Significant costs in implementing and maintaining high levels of controls in order to be SOX compliant;
  • Risk of hostile takeover; and
  • Pressure from outside forces on stock price. Since shares are now sold in the secondary market, the company no longer knows who own those shares and thus these unknown shareholders might push for company decision that are not in line with managements overall strategic decisions (i.e. the investor pushing for a short term decision to increase the stock price vs. management looking long term company stability).

Action Plans:

Go out and learn more about the public process and affects:

  • Listen to an earning calls as part of the SEC filling, really get a sense for the way executives talk and how you might be able to understand how owners react to their comments;
  • Review our history of the SEC and public markets articles on Finance First; and
  • Flip through a prospectus statements to get a better idea of what the SEC looks at when deciding to allow a company’s shares to be sold in the public market. Here’s a link to Snap Inc. (owners of Snapchat) https://www.sec.gov/Archives/edgar/data/1564408/000119312517029199/d270216ds1.htm

 

Footnotes:

[1] http://fortune.com/2016/05/07/facebook-stock-mark-zuckerberg-sec/

[2] https://corporatefinanceinstitute.com/resources/knowledge/finance/ipo-process/

[3] https://www.sec.gov/smallbusiness/exemptofferings

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