Why Companies Issue IPOs

The main reason why companies make the decision to go public, which means offering up stock in their company to anyone who wants to buy it, is to raise money. It’s not that making money isn’t the objective of companies anyway, but going public, involving issuing an initial public offering or IPO, raises money in a way that generally cannot be accomplished by any other means.

Companies raise money through two distinct means, by borrowing money, and by raising money by way of selling ownership in their companies. A company may rely solely on borrowing to raise the capital it needs to start and expand their businesses, or they may also rely on selling portions of the company, by taking on investors.

Investors aren’t going to want to just donate money to companies of course, and they do want something back, to seek to not only recoup their investment but to also seek to make a profit from it. Companies offer investors partial ownership in the company in exchange for these investments, called shares.

Why Companies Issue IPOsWhat then happens is that the investors now own a piece of the company and now have a claim on both their assets and their future profits. They are placed in essentially the same position as the people who started the company are, and any other investors who have since invested in it, according to how many shares each owns in it.

Companies can issue more shares, and this is a common practice, but these shares aren’t really created out of thin air, as creating more shares dilutes the value of the existing shares outstanding.

If, for instance, there are a million shares outstanding, and you own them all, and you issue another million, which is bought by another person, both of you own half the company now. The company initially had one million dollars’ worth of equity, based upon the book value of the company, and your selling another million doubled the book value of the company to two million dollars.

Your selling half of the company did not result in your losing any value, your million shares are still worth a million dollars, although the company is now worth twice that after the share issue. Since the company now has a million dollars of new money to invest in the business, provided that the company is well managed and its prospects are good, this new money can be put to work to expand the business and make more profit for you as well as provide the new investor the opportunity to grow his or her capital.

It’s Not Usually That Easy To Get Private Investment Capital

This example does result in your handing over at least some control of the company to private investors, although in this case you could set this up so you would own 51% of the company while the other investor would only control 49%, whenever we sell ownership in a company, we do risk losing control when we give up a majority stake in our company.

This may or may not be an issue, and generally speaking, companies don’t really worry about this too much, since all shareholders are out for the same thing, to look to seek out profit and especially sustainable profit.

If you are left with just a third of the company in our case, you may not worry that much about many owners controlling the other two thirds, as you may still be the largest shareholder and probably will be in a better position to organize the other shareholders than they would be by teaming up among themselves to oppose you.

In the realm of private investment, this is less likely to be the case, and companies taking on investors are quite limited to the number they can take on, and the focus also needs to be on those with substantial amounts of money to invest.

The more investors there are in a company, the more their power becomes diluted, and the fewer they are, the more power is invested in a few. In our example, let’s say we sold two thirds of the company to the investor, and the person could then decide to put themselves in place as the chairman and CEO, and oust you from the company entirely.

You would still own a third of the company but would have no real say in it, even though your common shares have voting rights. You would just get outvoted in any situation where the main shareholder held a contrary view.

IPOs Are About Adding Investment Liquidity

This is not the main issue with seeking private investors though, the lack of liquidity in the private investment market is by far the biggest problem with it, and this is the main reason that companies go public.

Imagine that you are seeking private investment for a certain amount of money for your company. This will require a search as well as considerable expense, which leads to a lot of inefficiency. There may be a lot of people who would be willing to invest modest amounts, but it simply will not be cost effective to reach these people, because doing so would be prohibitively inefficient.

So, what happens is that, if you are lucky, you may be able to attract a few well-heeled prospective investors to pitch the idea to, and you may not even be successful in raising any new capital at all from your efforts.

Meanwhile, all the smaller investors, and a lot of bigger ones as well, may be willing to invest but having to contact them privately places most of them outside the scope of your campaign.

This makes the stock of your company highly illiquid, meaning that it is a lot harder to buy and sell shares in your company compared to shares traded in the public market. Contrast this with the ease that one can buy shares in public companies with a single mouse click these days.

Publicly traded companies are also much more transparent, meaning that a lot of information is available to investors without your having to do anything, as a matter of public record. Instead of having to go through all the details about your company and then having lawyers on each side vet the deal, as well as negotiate it, you now can rely on investment banks to promote the sale of your company, and regulators to make your activities both transparent and compliant.

IPOs Attract investment on a Grand Scale

A company looking to go public can offer up massive amounts of shares to the public through these stock offerings, with relative ease. The amount of shares that can be offered through an IPO greatly surpasses what can be normally achieved with private companies, because now, instead of just having to focus on a few potential suitors, the entire investing public is now brought into the picture as potential investors.

The more investors that can be targeted with a share offering, the higher the potential for issuing shares, and the value of initial public offerings can range from the tens of millions of dollars with the smaller ones to the billions of dollars with the larger IPOs.

This not only allows for a huge influx in capital for the companies who issue the IPOs, it also allows for the pricing of a company’s shares after the stock issue to become more efficient.

Price is a function of supply and demand, and in this case, the supply is the number of shares that is issued with the IPO, so this is a constant. The variable factor is the demand, and this is where the added liquidity of public shares really shines.

When a company is privately owned, the value of their shares is priced according to the value of the company’s business, for the most part anyway, where with public offerings, the value of shares is simply a matter of how much demand there is for them.

This is why we see companies trading at different multiples of their value or earnings, and if the public is bullish on the shares of a particular company, this will cause the price of their shares to rise, irrespective of these multiples.

The bottom line here is that a company can see the value of its stock rise significantly over what it would have been valued in the private market, simply by offering their stock to the public. The market will price in a lot of other things into their stock price, especially a company’s future prospects, and we can therefore see companies who haven’t even made a cent in profits yet see their stock skyrocket.

Investment banks do their best to value the initial price of a stock with an IPO according to what they believe the company is worth, but often times the public steps in and ends up valuing it much higher, and the potential for this is what drives investor excitement with IPOs. Some of this might be hype but the market does not distinguish such things, at least in the present.

If you hold a good percentage of a company’s stock after the IPO, as is usually the case with owners and top executives, you of course would love to see your company’s stock rise in the secondary markets, as the value of your stake in the company will rise accordingly.

This can go the other way as well though, as not all IPOs go up in value once they hit the secondary markets, but the prospects for large gains from secondary trading certainly does inspire private company owners to look to cash in on their success more.

So, it’s not that there aren’t risks involved with companies that go public, but the potential for both the company to raise a lot of money and the private shareholders to make a lot of money is often too tempting a prospect to pass up.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.