Part 2 – Lesson 2

The Evolution of the Public Company


Public companies are not simply born into existence.  The typical public company started off as an idea by an individual or a few individuals, who started a private company and then slowly started to build their business over time.

For example, many readers may already know the story of Facebook.  The company started off as a concept and initially began its operations as a private company in 2004.  Similar to many early-stage tech companies, it took many years for Facebook to become profitable.  During this time, Facebook’s team raised capital from private investors and venture capital firms to fund the operations of the business.

Ultimately, as the business grew, Zuckerberg and his team decided to “take the company public” through an initial public offering (IPO).  Once private companies reach sufficient size (which is open to interpretation), many of these companies elect to offer shares of the company to public investors.  When a company goes public, they will typically list their shares on one of the two major stock exchanges in the United States – 1) New York Stock Exchange and 2) Nasdaq

There are numerous reasons for why a company would want to offer their shares to public investors.  Below are a few reasons:

  • Shareholders who invested in the business early on may want to sell a portion of their ownership, while other shareholders may want to retain their shares in the company. An IPO allows an “exit” mechanism for those shareholders wishing to sell while allowing other shareholders the opportunity to stay on board.  It is generally more difficult to buy and sell shares of private companies.
  • Going public allows employees of the company with significant stock holdings the opportunity to realize nice gains after many years of hard work.
  • The valuation multiple afforded to public companies may differ than private companies in the same industry. If management sees that there may be a valuation arbitrage between the private market and the public market, then, the management may recommend an IPO of the company to increase the valuation of the company.  For example, if private Company A could sell themselves for 8x EBITDA to a private buyer, but public companies in the same industry are trading at 10x EBITDA, it may make more sense to “sell” to the public markets by going through an IPO process.  We will discuss EBITDA multiples later in Part 2.
  • If a private company needs to raise capital but unable to find attractive capital from private investors, it may see better opportunities to raise capital through the public markets.
  • Many private companies feel that being a public company improves their credibility. Potential customers, partners, and vendors often perceive that a public company is more established and stable due to the improved visibility of public companies.
  • Similarly, some companies may feel that they are able to attract better employee talent due to the increased visibility that being a public company provides.

 

The IPO Process


Once a private company decides it is interested in going public, the management team will engage an investment bank such as Goldman Sachs, Morgan Stanley, Citigroup, etc. to execute an initial public offering of their shares.  For smaller companies or smaller offerings, there are a host of smaller investment banks that perform similar services.

Companies can either sell primary shares or secondary shares in the IPO.  Primary shares are new shares that the company is selling.  For example, if a company’s equity is worth $1 billion and it is selling $100 million in primary shares, then, this company will receive $100 million in proceeds back to the company.  Secondary shares are the sale of existing shares owned by shareholders wishing to sell.  For example, if a company with a $1 billion valuation is selling $100 million in secondary shares, then, this means that there are selling stockholders who own $100 million worth of stock who are selling in the IPO.  In this case, none of the $100 million in proceeds will go to the company.  Instead, those proceeds will go directly to the selling shareholders.  Companies may also sell primary shares and secondary shares in the IPO.

The investment bank plays an important role in the IPO process since an investment bank has extensive relationships with institutional investors, so the bank is well suited to act as an intermediary between the company and potential investors.  In the early stages of the IPO process, the bank will perform a valuation of the company to provide insight as to what type of valuation they believe investors are willing to pay for that company.

This can be a bit of a tug of war for the bank since companies want to sell their shares at the highest valuation, whereas the bank’s institutional investor clients want to pay the lowest valuation it can for those shares.  It is the bank’s role to balance the needs and wants of both sides by recommending a fair valuation for the offering of these shares.

In reality, there is often tension in this process.  Many companies that see their stock price jump 50% or more on their first day of trading may feel that they left money on the table by selling at too low of a price.  On the other side, when IPOs trade poorly on the first day, the banks can often be blamed for selling the shares at too high of a price to investors.  This is what happened during the IPO process for Facebook.  The stock price of FB fell significantly from the IPO price of $40 after it went public.  Many investors were angry at the banks and Facebook for selling shares at too high of a price to investors.  In retrospect (as of 2018), the $40 IPO price proved to be a bargain for FB stock.

Behind the scenes, the bank’s IPO team will also work with the company and its lawyers to draft and review necessary legal filings in order to go public.  For example, every private company must file an “S-1” with the SEC, which is the initial offering document that provides historic financial detail, a description of the business, and risk factors to potential investors.

In addition to setting an IPO price and assisting with the legal process, the investment banks will also assist the private company in meeting with potential investors prior to the IPO.  This process is called the “roadshow.”  The bank will set up meetings across the country to give management teams the opportunity to present their story and investment thesis for the company.  During the roadshow, investors are given the opportunity to ask management teams questions about their business and future strategy.

Following the roadshow, institutional investors provide indications to the bank as to many shares they’d like to purchase in the IPO.  Since the bank is typically only allotted a specific number of shares to sell (many companies will only sell a limited number of shares to the public), the bank will have to allocate shares to their institutional clients.

This can also create some tension in the IPO process.  For high demand IPOs, many of the large institutional investors may pressure banks to allocate more of the IPO shares to them, leaving smaller institutions with relatively small allocations and individual investors with virtually no allocation.  Unfortunately, in today’s environment, the IPO process is still geared to favor larger institutions over smaller investors, but there are early signs that this may change in the future.

 

The Financial Statement Impact of an IPO


In Part 1, Lesson 2, we reviewed how to adjust the balance sheet when John’s Pizzeria raises new equity.  The financial statement impact from an IPO is the same.  When a company sells primary shares (ie, the company is receiving cash for new shares sold), we raise the Shareholders’ Equity account and raise the cash account by the same amount.  Remember: Assets = Liabilities + Equity

If John decided to sell shares on the public market instead of investing his own cash, the initial balance sheet would essentially look identical:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets   Liabilities  
Cash $100,000    
    Shareholders’ Equity  
    Common Stock $100,000
Total Assets $100,000 Total Liabilities and Equity $100,000

In this case, we create a “Common Stock” account under shareholder’s equity to show that John has raised $100,000 through the sale of shares and we increase cash by $100,000 to reflect the receipt of $100,000 in cash.

However, in situations where existing shareholders of a private company are selling their shares to the public, then, there is no financial statement impact because the company receives no proceeds from the sale of secondary shares.