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Initial Public Offerings: Benefits and Drawbacks

Aug 17, 2007
Initial public offering can be an excellent way for a corporation to raise a large amount of capital. In an initial public offering, a corporation's shares are made available to the general public, thus providing a substantial influx of cash. The term applies only the first of such offerings, and any later offerings are referred to as secondary market offerings.

The benefits of an initial public offering are numerous. In addition to the financial gains, a company that decides to go public will also increase their public awareness and credibility.

Since public companies are more carefully and closely monitored than private companies, many investors feel that that they make for more stable investments. This increased demand is reflected in a higher overall valuation of the company. In addition, media outlets are generally more willing to cover public companies, so publicity generally increases.

Going public also increases the liquidity of company shares, further increasing the value of the company. At the initial public offering, a market is created for the company's shares, allowing investors to trade freely. That freedom to sell as necessary lowers the risk involved in holding shares, thereby increasing value.

For a company that has difficulties attracting and retaining quality employees, going public can offer another form of compensation. While shares of a company can certainly be offered as compensation by private companies, they are even more valuable when they have the liquidity and stability that comes with going public. In addition to increasing morale, stock options help to align the incentives of employees to those of the company.

The owner of the business may enjoy similar benefits after going public. His or her shares immediately take on a liquid, easily calculated value. While there are restrictions on when those shares may be traded, the overall value of the owner's percentage should increase after the initial public offering. In fact, many business owners decide to go public as an exit strategy. Once the company is public and shares can be sold, it becomes much easier to remove oneself from ownership.

For all the benefits of an initial public offering, the process is not without its drawbacks. Those who enjoy the autonomy of owning a private company may not enjoy having to answer to shareholders after going public. Instead of acting purely in the interest of the company's long-term well-being, management may feel pressured to take actions to maximize immediate returns.

Lack of control doesn't end with management decisions. The decision to go public can also leave a company vulnerable to hostile takeover if insiders don't retain a sufficient percentage of outstanding shares. Although extremely rare to occur, for that reason, some companies choose to restrict the number of shares issued. While this is effective, it also limits the total capital raised. As an alternative, other corporations issue shares with voting restrictions. These restricted shares are valued less than unrestricted shares, so this scenario also raises a smaller amount of capital.

Even before the initial public offering is complete, it can have some negative effects on the corporation. The process of going public is both time-consuming and expensive, and can divert employees from day-to-day activities. It's not unusual for underwriting fees and related expenses to cost 10-20% or more of the total funds generated by the offering.

After the initial public offering takes place, higher expenses continue in the form of increased reporting requirements. Taxes become more complicated, required disclosures increase, and the company becomes subject to a host of SEC requirements regarding activity of the company and its executives.

While an initial public offering isn't right for every company, the decision to go public is certainly appropriate for many. If a corporation can shoulder the burdens of additional expenses and profit-driven stockholders, it's certainly an option worth pursuing. The major influx of cash that going public can provide might be just what it takes to bring a company to the next level.
About the Author
Joel Arberman is the Managing Member of Public Financial Services, LLC. We help private companies through the process of becoming publicly traded via an initial public offering or direct public offering. Learn more at www.PublicFinancial.com
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