When any business angels or venture capitalists invest money into a business, there needs to be a system through which they can realize their investments at a future date. There are mainly 3 methods for raising capital or to attract the investors as follows:
- an Initial Public Offering (IPO);
- an acquisition;
- or a buyback of the investor’s stock by the company itself.
IPO is preferred by most investors for raising capital since it produces the highest valuation in the majority of cases. A firm opting for a buyback is more likely to be with IPO since the acquisition is not feasible. But in certain cases, the company organizes a re-financing in which it buys back the stock retained by the original investors.
Certainly, IPOs are sophisticated and generally produce the highest returns for their IPO investors; however, over an extended period of timeline, they aren’t always suitable for the entrepreneurs and the management team, for a plethora of reasons.
Advantages of Raising capital from IPO
The principal reason for a public offering is to raise a significant amount of money that does not have to be repaid. Hence the company does not need to part with previously existing capital to secure ownership.
- Follow-On Financing
A public company can boost more capital by allotting additional stock in a secondary offering, and hence it will create a backup source to earn funds for the benefit of the company.
- Realizing Prior Investments
Once a company is made public, the value of their investment is already known to the shareholders prior to the IPO. Moreover, their stock is liquid and can be sold on the stock market after the lock-up tenure is over. Therefore, prior investments may now be realized.
- Prestige and Visibility
A public company is more noticeable and has more reputation. This reputation helps the company in marketing and selling its products or services, outsourcing, hiring employees, and banking.
- Compensation for Employees
Stock options currently held by employees or offered in the future have a known value, and hence present an advantageous option for the employees to be compensated.
- Acquiring Other Companies
A public company can acquire other companies using their own shares, and hence acquiring smaller or similar firms for increasing their consumer base or capture a fresh consumer base becomes a valid option.
Disadvantages of Raising capital from IPO
- High Expenses
There are substantial expenses associated with going public. The expenses include legal and accounting fees, printing costs, and registration fees. These expenses are not refundable if the company does not actually go public, which occurs to about half the companies that initiate the IPO process and fail to complete it. Even if the company does go public, the underwriter’s commission includes approximately 7% of the money raised.
- Public Fishbowl
When a company goes public, SEBI regulations makes it compulsory that it reveal a great deal of information about the company, which until then has been private and only known to the insiders of the company. That information comprises of compensation of officers and directors, employee stock option plans, significant contracts and documents such as lease and consulting agreements, details about operations including business strategies, sales, the cost of sales, gross profits, net income, debt, and future plans. The IPO prospectus and other documents that have to be filed with the SEBI will be available in the public domain.
- Short-Term Time Horizon
After an IPO, shareholders and financial researchers assume increasing performance quarter by quarter. This expectation compels management to focus on maximizing short-term performance rather than on achieving long-term goals. Over the extended time period, this may negatively affect the sustainability of company profits.
- Management’s Time
After an IPO, the CEO and the CFO have to devote their time on public relations with the research analysts, financial journalists, institutional investors, other stockholders, and market makers—so om since they help make a market for the company’s stock. This can serve as an interference from the main job, which is running the company for optimal performance. Some public companies have executives separately whose main work is dealing with investor relations.
- Takeover Target
A public company sometimes becomes the target of a hostile takeover by another company. This kind of hostile takeover can create all manner of difficulties for the company.
- Employee Disenchantment
A rising stock price lifts the morale of employees with stock or stock options, but when the stock rises go down, it can be demoralizing—especially when an employee’s options go ‘‘underwater’’ (the price of the stock is less than the options price). Underwater options can make it difficult to motivate and retain key employees.
When an entrepreneur takes money from an investor including a business angel or a venture capitalist, there needs to be a future harvest when the investment can be realized. At initial phases, the profit is for the investors rather than the entrepreneurs. For any assistance regarding the funding, feel free to connect with us at LegalRaahi.