The Ups and Downs of Initial Public Offerings

Enticed by huge run-ups in the stock prices of companies that have recently gone public, owners and partners in privately held firms consider an initial public offering (IPO) as the road to riches. Many companies pursue IPOs as a means to increase the amount of available financing to the company and possibly generate billions for the owners in the process.

But there's many a bump, detour and dead end on that hoped-for path to bundles of stock market cash. And too many companies that think they're prepared for the big time with a New York Stock Exchange or Nasdaq IPO may be far from ready.

Going public—an initial public offering of stock—can be an effective means of raising cash for corporate ventures. But before undertaking the complex, expensive, time-consuming preparations and incurring the risks involved, the upside and downside of this move must be fully assessed. 

With an infusion of cash derived from the sale of stock, the company may grow its business without having to borrow from traditional sources, thus avoiding paying interest. This "free" cash spent on growth initiatives can eventuate in a better bottom line. New capital may be spent on marketing and advertising, hiring more experienced personnel who require lucrative compensation packages, research and development of new products and or services, renovation of physical plant or new construction, and dozens of other programs to expand the business and improve profitability.

With more cash in the company coffers, additional compensation can also be offered to investors, stakeholders, founders and owners, partners, senior management, and employees enrolled in stock ownership plans.

Company stock and stock options may be used as an effective incentive program. When recruiting talented senior management personnel, stock options are an attractive inducement. For employees, a performance-based stock or option bonus program is an effective means of increasing productivity and managerial successes. Stocks and options may also be used in other forms of compensation as well.

Once the company has gone public, additional equities may be easily sold to raise capital. A publicly traded company with stock that has performed successfully will usually find it easier to borrow money, and at a more favorable rate, when additional capital is needed. (For related reading, see: Introduction to Raising Capital.)

A publicly traded company may also have more leverage in negotiating with vendors and be more attractive to customers. This is a critical aspect of business, and a company that keeps vendor costs low may post better profit margins. Customers usually have a better perception of companies with a presence on a major stock exchange, another advantage over privately held companies. This is largely due to the regular audit and financial statement scrutiny public companies have to undergo on a regular basis.

A publicly traded company conveys a positive image (if business goes well) and attracts high-quality personnel at all levels, including senior management. Such companies are growth-oriented, they answer to a board of directors and shareholders who continually demand increased profitability, and are quick to rectify management problems and replace poorly performing senior executives. (For related reading, see: 5 Tips for Investing in IPOs.)

Once a company goes public, its finances and almost everything about it, including its business operations, is open to government and public scrutiny. Periodic audits are conducted, and quarterly and annual reports are required. Company finances and other business data are available to the public, which can sometimes work against company interests. A careful reading of these reports can accurately determine a company's cash flow and credit-worthiness, which may not be perceived as positive.

The company is subject to SEC oversight and regulations, including strict disclosure requirements. Among the required disclosures is information about senior management personnel, including compensation, which is often criticized by the stakeholders. (For related reading, see: Evaluating Executive Compensation.)

The company is subject to shareholder suits, whether warranted or not. Lawsuits may be based on allegations of self-trading or insider trading. They may challenge executive compensation or question major management decisions. A single, disgruntled shareholder bringing a suit can cause expensive and time-consuming trouble for a publicly traded firm.

Preparation for the IPO is expensive, complex and time-consuming. Lawyers, investment bankers and accountants are required, and often outside consultants must be hired. It can take a year or more to prepare for an IPO. Business and market conditions can change radically in this time, and it may no longer be a propitious time for an IPO, thus rendering the preparation work and expense useless.

The pressure for profitability each quarter is a difficult challenge for the senior management team. Failure to meet target numbers or forecasts often results in a decline in the stock price. Falling stock prices, moreover, stimulate additional dumping, further eroding the value of the equities.

Before buyers and original holders of the IPO stock may liquidate their positions, a no-sell period is often enforced to prevent immediate selloffs. During this period the price of the stock may decline, resulting in a loss. And again, business and market conditions may change during this period to the detriment of the stock price. (For related reading, see: IPO Lock-Ups Stop Insider Selling.)

From a distance, an IPO may look like a perfect means of making money. Close up, the many flaws become apparent. These should not dissuade a company from going public, however. Providing all the pros and cons have been understood and evaluated, and all the inherent risks assessed, if circumstances are right, an IPO may open profitable new opportunities for a company ready to be publicly traded.

But an IPO is not a guaranteed money maker for companies and/or shareholders. Some firms have been greatly disappointed by the price performance of IPOs. Finally, for companies currently being publicly traded, the opposite initiative—taking a public company private—may eventually prove more profitable than an IPO.

(For related reading, see: The Biggest IPO Flops.)