When and Why Do Companies ‘Go Public’?
‘Going public‘ is the process of selling (or ‘listing’) a company’s shares on a stock exchange. In investing it’s more commonly called an ‘IPO’ or Initial Public Offering.
‘Initial’, meaning the first time a company’s shares are traded on the exchange.
Why Do Companies Go Public?
Companies go public to sell their shares to investors. Remember, shares are just part-ownership of a large business.
Therefore, an IPO is simply a sale of shares from ‘private’ investors to public investors. The money from the sale can be used to buy-out a private investor or to fund a company’s growth.
For example, let’s say you started a successful manufacturing business which makes car parts. You have 3 factories around the state.
Unfortunately, although your business growing, you need $100 million to expand your business into another state and build two new factories.
- Go to the bank and get a loan
- Go public and sell part-ownership of your company to investors on the stock exchange
You agree to give up 20% of your company to get the $100 million, which you hope will make the company worth more in the future.
The company now has $100 million of cash which it will use to buy factories in another state.
When do Companies Go Public?
Because ‘going public’ is simply a process to sell part-ownership in a business, companies typically go public to raise money from new investors to fund future growth.
However, some companies may go public because a private shareholder wants to sell their stake, or just to enhance the company’s reputation.
Returning to our manufacturing example above. Five years after going public, the shares in your company are up 200%. You want to retire in a few years, so you decide that it’s time to start selling.
Because your company’s shares have performed well and there are thousands of shareholders on the stock exchange you can choose to slowly sell your shares over time or conduct a ‘block trade’ with another big investor.
Either way, because you listed your shares on the stock exchange it’s easier for other investors to buy the shares from you. Conversely, it’s easier for you to sell your shares.
Problems With ‘Going Public’
Sometimes, companies are criticised for going public ‘too early’ because the money they raised during the IPO didn’t get put to good use, or because they don’t have the skills to manage the stock exchange’s disclosure obligations.
In one of the most widely regarded investment books, The Intelligent Investor, Benjamin Graham wrote:
“In every case, investors have burned themselves on IPOs, have stayed away for at least two years, but have always returned for another scalding. For as long as stock markets have existed, investors have gone through this manic-depressive cycle.”
“In America’s first great IPO boom back in 1825, a man was said to have been squeezed to death in the stampede of speculators trying to buy shares in the new Bank of Southwark. The wealthiest buyers hired thugs to punch their way to the front of the line. Sure enough, by 1829, stocks had lost roughly 25% of their value.”
Another problem for investors buying shares during an IPO is that you’re often buying from someone who knows more about the company than you do. They are called ‘insiders’. Chances are, they have been ‘inside’ the company for many years.
So, it begs the question: Why are they selling their shares to you if it’s such a good investment?
It’s for these reasons some investors joke that ‘IPO’ should really stand for:
- It’s Probably Overpriced
- Imaginary Profits Only
- Insiders’ Private Opportunity