Before we get to the answer of Why companies go public, let’s take a step back. First of all, let’s try to understand the meaning of “going public“. It means that a private operating company offers its shares to the general public and opens its ownership to them.
Since this is the first time when a private company is offering a part of ownership in the form of shares to the general public, it is called an Initial Public Offering or IPO
This is what in simple terms, companies go public means.
Why Companies Go Public – Example
Now, to understand why a company would go public, let us imagine a scenario.
Suppose there is an entrepreneur (also called promoter) named Rajesh, who has a very promising idea of manufacturing high-quality linen shirts. Now, the very first question that would come to his mind would be where to get the initial investment from. So, he would pitch his idea to his friends, relatives, etc.
Suppose three of his relatives (Ajay, Brijesh and Chhavi) manage to invest some of their capital in X’s idea. In return for their investment, Rajesh will give them some percentage of ownership in his company. Ajay, Brijesh and Chhavi, in this case, will be called Angel Investors in business terms.
Angel investors are informal investors who inject their capital into startups and in return gain some percentage of ownership in it.
Now, the promoter (Rajesh), along with his own capital and the capital funded by his angel investors starts his business and it starts picking up steam in the local markets in some time. Once Rajesh gains complete confidence in the response of customers to his product, i.e. linen shirts, he will start expanding his business by launching new manufacturing plants and venturing out into new markets.
Now, with every plan of growth, arises a bigger challenge of obtaining funding. Naturally, the more aggressive the expansion plans, the more will be the capital requirement. There are many options available for raising these additional funds like:
Venture Capital – Wealthy investors inject their capital in growing businesses in exchange for some shareholding in the company. Also, they influence major decisions happening inside the company.
Banks – Banks can give short term and long term loans to companies for expansion purposes, which is known as debt for the business.
Private Equity – PE firms provide huge amounts of money in return for not only shareholding in the company but also members of the Board who have a say in every decision of the company.
IPO – By launching an IPO, the general public will subscribe to the shares by paying a certain price.
At different stages of the growth of a company, different kinds of decisions regarding funding are taken. When a business has matured significantly and already undergone a series of different types of fundings mentioned above, then, generally the decision of launching an IPO is taken.
However, there are very strict regulatory requirements (like consistent revenues, growth potential in the business sector, strong management team, etc.) that need to be fulfilled by a company before an IPO.
Now, let’s try to understand why a private company decides to go public. There are many reasons behind the decision of launching an IPO, which are:
By looking at the above scenario, we know that with each and every stage of a business, right from the generation of an idea to it becoming successful in every sense of the word, the major requirement is to gain access to capital. IPO is one of the ways of generating huge amounts of capital for a growing business.
There are considerable costs associated with loans taken from banks, etc. So, by decreasing the financial costs, there will be an obvious increase in the profits of the business.
With every business opportunity, there comes an inherent risk factor. With an increase in the number of shareholders, the risk associated with the business is also shared by all of them.
Providing Liquidity to Early Shareholders:
With the launch of an IPO, the existing shareholders of the business can cash out whole/part of their investment. For example: As per some reports, in 2017, shares worth more than $1 billion were sold after the launch of IPOs of different companies, resulting in huge profits to early investors.
Increase in Credibility and Visibility:
Going public in itself says a lot about the company’s stability and consistent performance. Also, as per the laws of Securities and Exchange Board of India (SEBI), as soon as a company goes public, it is liable to disclose all the information related to it, including its balance sheet, quarterly earnings, future plans etc. to the general public.
This information needs to be filed with SEBI regularly and is easily available on publicly available sources. It increases the visibility of the company in the eyes of the general public, which further plays a role in increasing its profitability.
Some companies give incentives to their employees in the form of “Employee Stock Ownership Plan” (ESOP), which give them shares of the company at extremely discounted prices.
Once, an IPO is launched, these employees experience huge appreciation in their capital because of these ESOPs. This would ultimately result in greater profitability of the companies as well.
With this, we wrap up our piece on why companies go public and what are the different ways they can choose from in order to raise funds. If you have any thoughts, let us know in the comments section below!
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