Taking Your Company Public — 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.
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 startup.
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 manoeuvre.
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 spectre 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. We will discuss this topic in the next issue.