Public companies are entities that trade their stocks on the public exchange market. Investors can become shareholders in a public company by purchasing shares of the company’s stock. The company is considered public since any interested investor can purchase shares of the company in the public exchange to become equity owners.
A public company is required to hold an annual general meeting (AGM) where shareholders vote to elect new members to the board of directors, debate policies, and formulate new policies, goals, and rules that will guide the operations of the company. The shareholders are entitled to a share of the profits generated by the company, and profits are distributed according to the number of shares that each shareholder owns.
A high proportion of public companies started as private companies, and they went public as a way of gaining access to a wider pool of funds to finance their projects or business operations. The process of becoming a public company involves going through an Initial Public Offering (IPO). The IPO must be approved by the Securities and Exchange Commission (SEC) and meet all regulatory requirements. The purpose of an IPO is to create funds for the issuing company by selling stock to the public.
1. Ability to raise funds by selling stock
One of the advantages that public companies enjoy is the ability to raise funds through the sale of the company’s stock to the public. Before becoming public, it is difficult to obtain large amounts of capital, other than through borrowing, to finance operations and new product offerings. A private entity can only get financing by reinvesting its profits, taking out a loan, or getting investments from a few wealthy individuals, who may not provide adequate capital to meet the company’s financial needs.
Public companies can raise funds in the primary and secondary markets by allowing the investing public to purchase shares of the company. The ability to raise large amounts of capital in public exchanges enables public companies to carry out capital-intensive activities. In return, the shareholders benefit from capital gains of stocks, as well as from dividend payments.
2. Availability of financial information
Public companies are required to file quarterly and annual financial statements and other mandatory documents with the SEC. The requirement allows shareholders, financial media, interested investors, and financial analysts to get access to additional information about the company.
The availability of financial information about the company makes it easier for analysts to calculate the valuation of the company. In contrast, private companies are not subject to legal requirements to make their financial reports public. Public companies are motivated to meet the disclosure requirements as a way of disseminating information about their financial performance and the future of the company to both current shareholders and potential investors.
Disadvantages of Public Companies
1. Increased government and regulatory scrutiny
Public companies are vulnerable to increased scrutiny from the government, regulatory agencies, and the public. The company must meet various mandatory reporting standards that are set by government entities such as the SEC and the IRS.
2. Strict adherence to global accounting standards
They must also prepare their financial reports in accordance with the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Shareholders are also entitled to key documents on the business activities of the company.
How Companies Become Public
The main process of becoming a public company is by selling stocks to the public through an IPO. Going into an IPO process is a complicated endeavor and the issuing company is required to hire an experienced investment bank to underwrite the issue. The success of the IPO will depend largely on the competency of the investment bank, and the issuer should consider factors such as industry expertise, reputation, and distribution when hiring an underwriter.
Here are some of the important steps involved when issuing an IPO:
1. Due diligence
The investment bank, the issuing company, and other advisors are required to conduct due diligence to determine the sustainability of the company’s business model. Due diligence focuses on financial, legal, commercial, operational, and tax areas to assess potential opportunities and risks. The due diligence investigation assures investors that the issuer’s registration statement is accurate and that it is based on actual market and competitor analysis.
The prospectus is prepared by the lead bank and includes information about the business, such as financial performance and expected future performance. The prospectus may be issued in two phases. A preliminary prospectus is often used to determine the acceptability of the company’s stocks to the public. It does not disclose the number or price of shares to be issued.
The final prospectus is filed with the SEC alongside other mandatory documents required, and it provides complete information about the offering and the number of stocks or certificates to be issued to investors. The prospectus helps investors get an understanding of the business and transaction, and helps them make an informed decision.
3. SEC approval
Once the SEC is satisfied that the issuing company has met all the requirements of the IPO, the underwriter and the issuing company agree on the issue date. The two parties are also required to agree on the offer price before the effective day of the issue, which is the price at which shares of stock will be initially sold to the public. Most often, IPOs are underpriced to ensure that all the shares offered to the public are sold or oversubscribed.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: