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Session 13: Public ownership

OBJECTIVE: Going public is not a realistic choice for most businesses. But for a business with a growing and sustainable product or service, public ownership could become an ultimate goal. At the same time, it is a highly complex process. This session will help you evaluate whether going public is right for your business.

  • A potential goal for selected businesses
    • It is a long road
    • The Sarbanes-Oxley Act of 2002
  • What does it take to go public?
    • A track record
    • A history of earnings growth
    • A strong potential for future growth
    • A sustainable market for your product or service
    • Strength in governance and accounting
    • A highly qualified management team
    • A clearly stated growth program
  • Advantages of public ownership
    • Access capital
    • Higher valuation of the company
    • A higher company profile
    • Use stock as currency to acquire other companies
    • You are a more attractive suitor for potential acquisitions
    • Establish a public valuation of your company
    • Provide liquidity for the owners
    • Stock options provide incentives for key employees
    • Facilitate exit strategy
  • Disadvantages of public ownership
    • Your books are open to scrutiny
    • Higher accounting costs
    • Majority of independent directors
    • Ownership valuation subject to market fluctuation
    • You will lose some flexibility in operating your business
  • Going public
    • The initial public (IPO)
    • Hiring the going-public team
    • Audited financial statements
    • Registration statement and prospectus
    • Appoint independent board members
    • Appoint investment banker
    • Create an audit committee
    • Appoint an independent board of directors
  • Helpful Tools
    • "Roadmap for an IPO, A guide to going public"
  • Top ten do's and don'ts
  • Session Feedback
  • Session Quiz
      Public ownership

A potential goal for selected businesses

It is a long road
Going public is not a realistic option for most businesses. But for an entrepreneur with a growing and sustainable product or service, public ownership could become an ultimate goal. It is a costly and complex transition that cannot fully be covered in the scope of this session. Our goal will be give you a broad overview of the advantages and disadvantages. It will be worth reviewing "Expanding and handling problems" from session 15 in the Starting My Own Business course.

If you have ambitions for future public ownership, it is a good idea to begin operating like one long before the act. This could include beginning to build a board, including a majority of independent directors, and having your annual financial statements audited. By acting like you're public before you actually are will go a long way in smoothing out the complex transition.

The Sarbanes Oxley Act of 2002 (SOX)
The Sarbanes Oxley Act (S0X) was initiated by the U.S. Congress in reaction to the financial melt-down of a number of what were thought to be strong public companies. It was designed to emphasize corporate responsibility in reporting, strengthen accounting practices, protect corporate whistleblowers that disclose illegal activities and require that a majority of board members be from outside the company.

While SOX provides that all publicly traded corporations must meet its requirements, there are some exemptions that are allowed for the purpose of helping smaller firms gain access to capital:

  • Private offerings to a limited number
  • Offerings of limited size
  • Intrastate offerings

For your initial venture into public ownership, you might want to consider qualifying for one or more of these exemptions permitted by SOX regulations. Then over time your corporate governance could be enhanced to qualify fully as a publicly traded corporation. This will require the retention of a good securities attorney from the very outset.

What does it take to go public?

John Powers Attorney-at-Law John Powers
Attorney-at-Law
Play Video
Consideration and reasons for public ownership
A track record
Public ownership will put you under the scrutiny of the investment banking world. As a candidate for public ownership, you will need to earn the public trust by already having achieved success over a period of time.

You will be looked upon as "small cap" stock. While investors have different viewpoints on "small caps" your small size could be perceived as an advantage because small firms can grow more rapidly than large ones. When Walmart adds ten stores, the impact is negligible. But when a small cap adds ten stores, the grow rate could be noticeable.

A history of earnings
While it is not uncommon for firms in the Internet technology field to go public on the strength of future earnings, a history that shows an upward trend of earnings usually plays an important role in the success of new public offerings. Stockholders don't like surprises in earning reports so a past history of highly volatile earnings could greatly diminish the appetites of prospective stockholders.

A strong potential for future growth
While a track record of consistent and growing earnings is important, there is another characteristic that is absolutely essential, you will need to demonstrate that your present operation can be scaled up to far higher levels. This requirement could eliminate many solid companies from the prospect of public ownership. Here are some examples of good and poor prospects:

Poor prospects:

  • A highly profitable auto (or other) dealership. The risk of future elimination of the dealership function in the marketing chain could make it an unacceptable shareholder investment.
  • A business or service dealing in a commodity. Unless the company has a long-term advantage of being the lowest cost producer, earnings will be limited by the lack of pricing power. Examples would include the airline industry, textile companies or steel producers.
  • A product or service that is an unsuitable for geographical proliferation including franchising.

Good prospects:

  • Ray Kroc realized that a hamburger stand in San Bernardino, California was a footprint that could be replicated via franchising in many other places.
  • Paul Iam created a line of premium pet foods. Mr. Iam later sold out to Proctor and Gamble who expanded it into world-wide markets.
  • Amazon.com was the "firstest with the mostest" to exploit rapidly emerging appetite for on-line marketing.
  • A single pie shop became the model for expanding into a chain of bakery-restaurants (Marie Callender).

A sustainable market for your product or service
It will be important that your product be capable of serving a widespread and ongoing need in perhaps a unique or better way. This would eliminate products or services that are short-lived in their usefulness, style or appeal such as:

  • Bookstores. Borders, a publicly owned company, is in financial difficulty because of a strong trend toward e-reading.
  • The George Foreman grill is an example of a kitchen appliance that became a fascination as well as an outstanding solution to busy working people. But perhaps an unlikely product for public ownership because of its potentially lacking long-term pricing power.
  • A single, proprietary, patented product. A granted patent has a life of 20 years. A design patent only endures for 14 years. The potential stockholder will ask: "And then what?" Publicly owned drug companies overcome this problem by having many new patented products in the developmental pipeline.

Strength in governance and accounting
You will need to have strong compliance with regulatory requirements in place well before your IPO to demonstrate your readiness to operate at expected levels of compliance. A good place to start would be to have a discussion with your CPA to determine the additional cost of beginning to have your annual financial statements audited. Your chief financial officer must be capable of upgrading and managing financial systems and reporting requirements as well as internal controls, cash and debt management. Accounting expenses could represent the largest single expense in your readiness process. Your lawyer will also have recommendations on other governance issues that you could be begin to implement. To review the different levels of audits, go to the importance of having audited statements from the first session of this course.

A highly qualified management team
You will need highly qualified operating managers. Providing key managers with stock options may be an appropriate way to motivate key people and also provide an incentive in recruiting managers for key areas such as finance, public relations, production or marketing. Also keep in mind:

  • The CEO should be an outstanding spokesperson in handling interviews, press releases, news stories as well as internal communications with company employees.
  • Managers in all operating functions must be financially trained and in tune with overall, long-term growth programs including sales, earnings and market share.

A clearly stated growth program.
Prospective shareholders will need to know just how you plan to scale up your present operation. You will need to explain this in simple language that anyone can understand. :

  • A successful retail establishment or service could be the beginning of public ownership. You should conservatively describe how this footprint operation can become a template for more to come.
  • A successful chain of fast food stores could outline how a franchised program will be utilized to build a national or international chain.
  • A well-operated, localized direct selling firm could spell out how the business will be expanded internationally. (Publicly owned Avon's annual sales are over $10 billion U.S. dollars.)

In outlining your growth program avoid statistical forecasts, complex wording and exaggeration. Instead, understate your goals and overstate the time it will take to get them accomplished. Never disappoint your prospective co-owners by failing to meet your stated objectives.

Advantages of public ownership

Phil Holland Founder, My Own Business Phil Holland
Founder, My Own Business
Play Video
What are the benefits to becoming a publicly owned company?
Access of capital
The greatest benefit of public ownership is raising money. This is accomplished by the sale of stock in an initial public offering (IPO). Your stock can also provide compensation for either key employees or employees as a whole. For example Walmart's associate purchase plan provides a match of 15% for purchases up to a stated amount each year. Employees with an ownership interest become more dedicated and company-oriented in their outlook.

Capital raised by an IPO can provide for growth, for acquisitions, pay off debt or provide funds for research and development. Later on if you require additional capital you can go back to the public with additional offerings. Public ownership is also good for society as a whole by providing funding to enable growing companies to create new jobs, help improve the standard of living as well as overall social conditions.

Higher valuation of the company
As a publicly owned company, the overall valuation of the company will increase for a number of reasons:

  • The additional liquidity achieved will add value by lessening the risk of cash flow shortfalls and problems servicing debt.
  • Assuming your success is ongoing, people will place a higher valuation because they will have much better and reliable insights into your financial and operating affairs.
  • There is a value placed on having a market valuation available at all times.

A higher company profile
Enterprise Rent-A-Car © is world-wide and has 65,000 employees but doesn't have a big profile in the financial reporting community because it is privately owned. As a publicly owned company, furnishing financial results quarterly to the public, you now become newsworthy to the reporting media as well as your customers, suppliers and your important industry relationships.

Use stock as currency to acquire other companies
Your capacity to purchase other businesses will expand by either using cash proceeds from the sale of stock or by using the stock itself as currency. Using stock to make acquisitions is of special benefit when the public is placing a high valuation on your stock.

But be careful...in some cases the seller may want a provision to receive more stock in event of future declines in value. A famous example is the Denny's Restaurants acquisition of Winchell's Donuts. Over time Vern Winchell ended up controlling Denny's after their stock declined.

You are a more attractive suitor for acquired companies
An owner that is considering selling you his or her business has spent a lifetime building the firm. There will be an emotional component as well as a monetary interest in evaluating how their life's work is to be carried forward. As a publicly owned firm, you will have a higher level of appeal than a private firm. The owners of a selling company you acquire can be assured that your audited financials and provisions of SOX oversight will make for a stronger and more transparent future for their business.

Ken Blake CPA Ken Blake
CPA
Play Video
When should a company have their financial statements audited?
Establish a public valuation of your company
A big problem as a private firm is that the value of your firm is unclear and subject to different perceived valuations. But as a publicly traded firm, the day to day valuation of the firm is clearly established by the market. But keep in mind that a poor valuation of your company would obviously not be an advantage.

Provide liquidity for the owners
A big drawback to private ownership is you can be asset rich and cash poor. It is not uncommon for business owners to live frugally for years while earnings are used build the business. Earnings go into the business rather than into their pockets. But the ownership of a publicly traded firm provides the owner liquidity to raise cash by sales of stock.

The stock will provide for stock option plans for key employees
As a public company you will be able to recruit and hold more highly qualified key employees by offering stock options. The company stock will not only bring you top management talent but stock option plans can be used to motivate employees as a whole. A key to Sam Walton's success with Wal-Mart was stock options from the very outset which created a zeal of ownership at all levels.

Keep in mind that private companies can also implement stock option plans but the main difference is that it's easier for employees to "cash out" when the stock is publicly traded.

Facilitate exit strategy
Public ownership of stock will provide both a valuation of the stock plus liquidity of ownership that make it much easier for your ultimate retirement as founder.

Disadvantages of public ownership

Ken Blake CPA Ken Blake
CPA
Play Video
Should a small business have their financial statements reviewed by a CPA?
Your books will be open to the public and your competition
  • As a publicly owned company you will be required to keep shareholders informed about your operations, financial condition and any adverse circumstances. In doing so you will also be sharing your overall corporate mission and finances with your competitors. Your quarterly and annual report to the SEC is going to disclose comprehensive details of your company's operation and performance. But not all your trade secrets are subject to disclosure. Your intellectual property and patents should be protected by patents and copyright. Your truly secret formulas and trade secrets can be withheld from public access, such as Coke's © syrup formulation.
  • But the disclosures made as a public company also have advantages. Larger companies that may be interested in acquiring you will have assurance that you are providing a transparent and accurate database of information.

Higher accounting costs
Your accounting costs for at least two years prior to going public and while public will be substantially increased due to the requirements of audited financial statements and compliance with SOX. Your accounting department will need staff to prepare quarterly and annual financial information provided in formats required by the SEC and within their stringent timing requirements.

A majority of independent directors
Sarbanes-Oxley also requires that a majority of your board of directors be people from outside the company. Many potential board members have become more reluctant to join public boards because risks associated with government oversight of public companies and higher litigation risks. Compensation paid to board members has therefore escalated significantly.

Your ownership valuation will be subject to market fluctuations
Your ownership valuation is going to fluctuate with the stock market. There will be times that your company will be valued at higher than its intrinsic value and other times where it can be much below its true value.

You will lose some flexibility in operating your business
Confirming to state and federal securities laws, especially on occasions when you are required to get shareholder approval for your actions, will impose constraints not present when operating a privately owned business. In most instances however such restraints will be constructive in helping avoid business mistakes that could result without the restraints in place.

Going public

Phil Holland Founder, My Own Business Phil Holland
Founder, My Own Business
Play Video
What are the steps necessary to take my company public?
Steps in the process
  • The initial public offering (IPO) is a one way and expensive street. Preparation should begin at least two years before the targeted date.
  • Your going-public team will include an investment banking and underwriting firm, law firm, accounting advisors and an independent auditor.
  • Annual audited financial statements will be required at for at least two years prior to going public.
  • A registration statement and a prospectus must be created by the team.
  • A board of directors with a majority of independent directors must be appointed.
  • Create an outside audit committee.

Helpful Tools

For entrepreneurs with a serious interest in public ownership, we recommend the online tutorial "Roadmap for an IPO, A guide to going public" published by the accounting firm of PricewaterhouseCoopers (PwC):

Top Ten Do's and Don'ts

THE TOP TEN DO'S
  • Assess if your business would be attractive to the public.
  • Start operating as if you're already public.
  • Begin requiring annual audited financial reports.
  • Begin building your board now.
  • Consider starting with a private offering.
  • Be prepared for an extended and complex process.
  • Get estimates of the overall costs involved.
  • Prepare for public disclosure of your financials and plans.
  • Keep your key employees informed of the process.
  • Get started with an outside audit committee.
THE TOP TEN DON'TS
  • Consider an IPO if lacking significant growth potential.
  • Think of an IPO as an event--it's a process.
  • Be secretive about any adverse factors.
  • Overlook understanding Sarbanes-Oxley provisions.
  • Plan for full control of your board.
  • Consider IPO if your product or service lacks appeal.
  • Consider IPO if you place high value on privacy.
  • Take media criticism too seriously.
  • Overlook having intellectual property rights protected.
  • Avoid using a prudent approach to operating your business.

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