Going public

What Is Going Public?

Going public refers to the transformative process by which a privately held company offers its shares of stock to the general public for the first time, typically through an Initial Public Offering (IPO). This strategic move allows a company to raise capital from a broad base of investors, transitioning from private ownership to a publicly traded entity. The decision to go public falls under corporate finance, as it fundamentally alters a company's capital structure and reporting obligations. After its IPO, a company's shares are listed and traded on a stock exchange, such as the New York Stock Exchange (NYSE) or Nasdaq. This enables greater liquidity for existing shareholders and provides a mechanism for future capital raises.

History and Origin

The concept of public ownership and trading shares has roots dating back to Ancient Rome and medieval Europe with the emergence of joint-stock companies. However, the first official stock exchange was established in 1602 in Amsterdam, primarily for trading shares of the Dutch East India Company, which is considered the world's first public company.²¹, ²² This laid the groundwork for modern stock markets, introducing features like listing fees and regular trading hours.²⁰

In the United States, organized trading in stocks began in 1792 with the Buttonwood Agreement, which eventually led to the formation of the New York Stock Exchange (NYSE) 25 years later.¹⁹ Initially, trading focused on government bonds and bank stocks, but by the mid-19th century, with the industrial revolution and railroad expansion, stock trading grew significantly. The late 20th century saw the rise of exchanges like the Nasdaq, which became a favored venue for technology companies.¹⁸

Key Takeaways

• Going public involves a private company selling its shares to the public for the first time, typically through an Initial Public Offering (IPO).
• It provides access to significant capital and can enhance a company's public profile and brand recognition.
• The process entails rigorous regulatory compliance, including registration with the Securities and Exchange Commission (SEC) and adherence to exchange listing requirements.
• Public companies face ongoing reporting obligations, increased scrutiny, and higher operating costs.
• Alternatives to a traditional IPO include direct listings and special purpose acquisition companies (SPACs).

Formula and Calculation

While "going public" itself isn't a single formulaic calculation, the process involves extensive financial valuation to determine the initial offering price of the shares. Key metrics and valuation methods are employed, including:

1. Valuation Multiples:
Companies often use multiples derived from comparable public companies to estimate their own value. Common multiples include:

• Enterprise Value (EV) / Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
  $\text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}}$
• Price-to-Earnings (P/E) Ratio:
  $\text{P/E Ratio} = \frac{\text{Share Price}}{\text{Earnings Per Share}}$
• EV / Revenue:
  $\text{EV/Revenue} = \frac{\text{Enterprise Value}}{\text{Revenue}}$

2. Discounted Cash Flow (DCF) Analysis:
This method estimates the present value of a company's projected future free cash flows. The formula for the present value of future cash flows is:
$\text{PV} = \sum_{t=1}^{n} \frac{\text{CF}_t}{(1 + r)^t} + \frac{\text{TV}}{(1 + r)^n}$
Where:

• (\text{CF}_t) = Cash flow in period t
• (r) = Discount rate (often the Weighted Average Cost of Capital)
• (n) = Number of periods
• (\text{TV}) = Terminal Value (the value of cash flows beyond the projection period)

These valuations help underwriters determine a fair offering price for the new stock, aiming to balance capital raised with investor demand.

Interpreting the Going Public Process

Interpreting the process of going public involves understanding its strategic implications for a company. When a company decides to go public, it signifies a mature stage in its business lifecycle, often driven by the need for significant capital to fund growth, acquisitions, or debt repayment.¹⁶, ¹⁷

For investors, a company going public presents an opportunity to invest in a potentially high-growth entity. The IPO prospectus, filed with the SEC as Form S-1, provides extensive details about the company's business model, financial performance, risks, and management team, allowing investors to assess the investment opportunity.¹⁵ However, investing in an IPO carries inherent risks, as the initial stock price can be subject to significant volatility once trading begins.

Hypothetical Example

Imagine "GreenTech Solutions," a privately held company specializing in renewable energy technology. GreenTech has developed innovative solar panel designs and secured several large contracts. To scale its manufacturing and expand into new markets, the company needs substantial capital beyond what private financing can provide.

GreenTech's management decides to go public. They hire an investment bank to act as the lead underwriter. The investment bank performs a thorough due diligence, valuing GreenTech using various methods, including comparing it to publicly traded clean energy companies. They determine a preliminary valuation and propose an offering price range.

Next, GreenTech and its underwriters prepare a registration statement (Form S-1) to file with the SEC. This document details GreenTech's financial statements, business operations, growth strategies, and the risks associated with investing in the company. Once the SEC reviews and declares the registration statement effective, GreenTech's management, along with the underwriters, embarks on a "roadshow," presenting to institutional investors to generate interest and gauge demand for the shares.

Based on investor feedback, the final offering price is set at $20 per share, and 10 million shares are offered, raising $200 million for GreenTech. On the designated IPO date, GreenTech Solutions' shares begin trading on the Nasdaq stock exchange under the ticker symbol "GTS." The company, once private, is now a public entity, with its shares available to individual and institutional investors alike.

Practical Applications

Going public has several practical applications across finance and business:

• Capital Formation: The primary application is to raise a significant amount of equity capital from the public markets to fund expansion, research and development, or pay down existing debt.¹³, ¹⁴
• Enhanced Visibility and Prestige: A public listing can increase a company's brand recognition and perceived credibility among customers, suppliers, and potential employees.
• Liquidity for Early Investors and Employees: Going public provides an exit strategy for early investors, such as venture capitalists and private equity firms, and allows employees with stock options to convert their equity into cash.
• Acquisition Currency: Publicly traded stock can be used as a non-cash currency for mergers and acquisitions, making it easier for companies to grow through strategic purchases.
• Employee Incentives: Public companies can offer stock options and restricted stock units (RSUs) as part of compensation packages, aligning employee interests with shareholder value.
• Market Valuation Benchmark: Being publicly traded provides a clear, real-time market valuation for the company, which can be useful for benchmarking performance and informing strategic decisions. Companies must also meet specific listing requirements, such as those set by the Nasdaq, which include minimum share price, market value, and corporate governance standards.¹¹, ¹²

Limitations and Criticisms

Despite the advantages, going public comes with significant limitations and criticisms:

• Increased Regulatory Burden and Costs: Public companies are subject to extensive and ongoing regulatory compliance requirements, primarily those imposed by the SEC and the chosen stock exchange. This includes filing quarterly and annual reports, adhering to Sarbanes-Oxley Act provisions, and maintaining robust internal controls.¹⁰ These compliance efforts can be costly and time-consuming, requiring dedicated legal, accounting, and investor relations teams.
• Loss of Control and Public Scrutiny: Founders and early investors may experience a dilution of ownership and control as new shares are issued to the public. Furthermore, public companies operate under constant scrutiny from investors, analysts, and the media, which can lead to short-term pressure to meet earnings targets rather than focusing on long-term strategic goals.
• Volatile Market Conditions: The timing of an IPO is crucial, and unfavorable market conditions can lead to a lower-than-expected valuation or even a postponed offering.⁹ The initial trading of shares can be highly volatile, potentially leading to a "pop" or "flop" on the first day.
• Reporting and Disclosure: Companies must disclose sensitive financial and operational information to the public, which competitors can access.
• Alternatives and Criticisms of IPO Process: The traditional IPO process, involving underwriters and roadshows, has been criticized for being expensive and potentially undervaluing companies. This has led to the rise of alternative methods like direct listings and Special Purpose Acquisition Companies (SPACs), though SPACs have also faced scrutiny regarding investor protection and transparency.⁸

Going Public vs. Direct Listing

While going public traditionally refers to an Initial Public Offering (IPO), a "direct listing" is an alternative method for a private company to become publicly traded. The key differences lie in how shares are offered and capital is raised.

In a traditional going public via an IPO, a company issues new shares to the public to raise fresh capital. This process involves investment banks as underwriters who help price and sell the shares, often through a "roadshow" to institutional investors. The underwriters guarantee a certain amount of capital raised and take a fee for their services.⁷

A direct listing, in contrast, does not involve issuing new shares or raising new capital. Instead, existing private shares are simply listed directly on a stock exchange, allowing current shareholders to sell their shares to the public. There are no underwriters or roadshows involved, which can save the company significant fees and potentially lead to a more direct price discovery based on supply and demand. However, without the capital-raising component of an IPO, a direct listing may not be suitable for companies that need to raise substantial new funds.

FAQs

Why do companies go public?

Companies go public primarily to raise significant capital for growth, expansion, or debt reduction. It also provides liquidity for early investors and employees, increases public visibility, and can be used as currency for acquisitions.⁶

What are the main requirements for a company to go public?

To go public, companies must meet rigorous financial and corporate governance standards set by regulatory bodies like the SEC and the chosen stock exchange (e.g., Nasdaq or NYSE). These include minimum revenue, earnings, market capitalization, and a certain number of public shares.⁴, ⁵

What is a "roadshow" in the context of an IPO?

A roadshow is a series of presentations given by a company's management and its underwriters to potential institutional investors. The purpose is to generate interest, gauge demand for the shares, and help determine the final offering price before the shares begin trading publicly.³

What is a Form S-1?

Form S-1 is a registration statement required by the U.S. Securities and Exchange Commission (SEC) that companies must file before offering securities to the public for the first time. It provides comprehensive information about the company's business, financial condition, management, and the offering itself.²

What are the downsides of going public?

The downsides include increased regulatory burdens and compliance costs, loss of some control for existing shareholders, intense public scrutiny, and the potential for stock price volatility. Companies also face ongoing reporting obligations that require transparency regarding their operations and financials.¹