Entrepreneurs with visions of taking their company public one day may look forward to announcing their IPO by ringing the bell at the stock exchange on Wall Street and celebrating at an extravagant closing dinner with the founder team. These heady pre-IPO dreams may quickly run into a number of significant real world challenges, however, that are regularly faced by the management of public companies. This blog post reviews some of the serious issues that public firms regularly confront, which should be weighed carefully by private company owners before they decide to move into the public market.
The Cost Factor – Public Companies Are Extensively Regulated
The vast difference in the way that public and private companies are managed results from the extensive federal regulations that govern the operation of public firms. Moving into the public realm requires the company’s management to learn an entirely new language filled with acronyms, e.g., just a few of these are Sarbanes Oxley (SOX), the Securities & Exchange Commission (SEC) and the Federal Trade Commission (FTC). The dictates of federal law and the regulations promulgated by federal agencies will require the company to engage in detailed internal compliance procedures, file financial reports, accept audits by independent third parties of their financial performance and abide by operating requirements that did not exist when the company flourished as a private, closely-held business.
While a successful IPO will generate a sizable financial war chest, there are trade offs that should be considered by the company founders. Once the company owners successfully take the business public, their management team will be required to spend more time and incur much greater expense complying with the federal regulatory scheme. Research indicates that the cost for a small company to enter the IPO marketplace averages about $2.5 million. And after a small-cap company becomes public, it can then expect to pay an average of about $1.5 million annually in compliance costs. (Read: The Cost of Regulation on Small-Cap Companies)
The Short-Term Pressure Factor – SEC Reporting Requirements
A private company founder accustomed to pursuing a long term vision for the company is likely to have a rude awakening when forced to deal with the unyielding demands of Wall Street, which focuses on quarterly financial results. The SEC mandates that all public companies issue regular quarterly and annual financial reports to all shareholders, and this reporting schedule results in a short term mind set for both managers and investors. The Atlantic magazine has dived into the data regarding quarterly reporting requirements and reports that:
“The average holding time for stocks has fallen from eight years in 1960 to eight months in 2016. Almost 80 percent of chief financial officers at 400 of America’s largest public companies say they would sacrifice a firm’s economic value to meet the quarter’s earnings expectations. And companies are spending more and more on purchasing their own shares to drive stock prices up, rather than investing in equipment or employees.” (Read: How to Stop Short-Term Thinking at America’s Companies)
This short term focus on financial results imposes such rigid constraints on the operation of the business that, for a private company founder, it can take the fun and passion out of running the business. A question that company founders will want to evaluate before taking the plunge and go public is whether the big payday that the company will secure from the IPO is truly worth experiencing the change in vision to a short-term focus for the business.
The Control Factor – Threats to Management From Shareholder Activism
Apart from cost factors, private company founders who take their company public may be stepping into the lion’s den of shareholder activism, which threatens their control over the business. This threat is due to the huge increase in the size and reach of institutional investors, which collectively own 70-80% of all public companies. The Harvard Law School Forum reports that as of 2014, the number of activist hedge funds across the globe had dramatically increased during the past decade with a total of more than $100 million under management, and during the period of 2003 through May 2014, 275 new activist hedge funds were launched. (Read: Shareholder Activism: Who, What, When, and How?)
The result is that a small number of fund managers control substantial ownership stakes at most public companies, and they frequently use proxy fights and other tools to pressure the businesses in which they invest to make major changes. Some current shareholder activists are legitimately concerned about environmental or social issues, but others cloak themselves in the garb of “do gooders” when in fact, they are the same or similar to the corporate raiders of the 1980’s. These shareholder activists are looking out solely for their own interests in disregard of what is best for the company or the other shareholders, and they may demand immediate changes to “unlock” unrealized value at the company, and then promptly exit the business as soon as the stock price increases. It is a sometimes overlooked fact that these shareholder activists may be wrong about their assessments of the business, and the pressure they apply on the company may therefore be misguided and result in harm to the business.
Even if an activist investor’s demands help produce favorable financial results for the company in the short run, the aggressive tactics these activists employ often create a large distraction for the company’s management. Moreover, there are other negative impacts that activist investors can have on the business. According to the World Economic Forum:
“. . . activist investors tend to have a negative impact on two crucial areas of modern corporate life: sustainability and diversity. There has been an observable decline in diversity on corporate boards after campaigns by activist investors. Some CEOs report that they had to cut back or scrap environmental initiatives and sustainability targets under pressure from activist investors. This raises the question of whether these investors are creating sustainable corporate value over time, or just squeezing out short-term value via buy-back programs, extra dividend payments or similar types of financial engineering.” (Read: Activist Investors are More Powerful Than Ever)
In the private company space, the company’s managers largely operate anonymously, which gives them the freedom to take chances, to make mistakes and then adapt quickly to the marketplace and implement changes that will help the business to succeed. By sharp contrast, public companies are subject to intense scrutiny, and every significant action of the management team will be open to criticism. The company’s annual meetings are open to all stockholders of the company, as well as industry analysts and the press, and the company’s officers may well be pressed to provide answers on host of topics related to the business.
As a related point, when companies operate in the private sphere, they will have an easier time keeping their business plans private. Once the company goes public, however, the officers have a duty to share information about the company’s projections, plans and goals. Moreover, the investment community and industry analysts will be engaging in rampant speculation about what they expect the company to do in the future and they will leak/report on information that may or may not be fully accurate. This kind of ongoing, 24-7 public scrutiny therefore adds another layer of difficulty in successfully managing a public company.
Investopedia sets out the dynamic choice that company owners will face when they are considering moving forward with a potential public offering for the business:
“By selling all or part of a business in a public offering, companies that go public receive an immediate influx of capital. While this might appeal to some companies, others understand that public ownership comes at a price. By choosing to stay private, they do not have to report to a large group of shareholders and are able to keep their business plans and finances private.” (Read: Why Companies Stay Private)
The access to public markets is tempting. Having access to a substantial pool of capital will provide the company with the opportunity to compete and grow in ways may not have been possible when it operated as a private business. But the factors discussed above that apply to public companies—the strict regulatory scheme, increased administrative costs, loss of control, potential shareholder fights and intense public scrutiny—may make the trade-off not worth the influx of capital that will be obtained through the IPO. These factors cause many company founders to leave not long after the IPO to return to the freedom, flexibility and lack of intense scrutiny that is associated with private companies.
Five different entrepreneurs who experienced the IPO process were interviewed earlier this year by Fast Company magazine, and they shared highlights of what they learned from their experience in this interesting article. One of the comments that stood out is the following:
“At times, a public company’s management team has to ignore the market’s relentless short-term focus to favor necessary longer-term strategic decisions.” (Read: 5 founders weigh in on the highs and lows of the IPO)