Public and Private Corporations

A corporation can either be regarded as private or public. This classification is determined by the following factors:

• Issuance of shares.
• Exchange listing and share transfer.
• Registration and disclosure requirements.

1. Issuance of Shares

Public Companies

Public companies may issue additional shares in the capital markets to raise huge amounts of capital from investors. The investors can, then, trade among themselves in the secondary market.

Private Companies

In contrast, private companies invite investors to purchase their shares through a private placement memorandum (PPM) (also called offering memorandum). This is a document that describes a business, the terms of the offering, and the risks involved in investing in the company.

Private securities are typically unregulated. As such, only accredited investors may be invited to purchase the shares. Accredited investors are sophisticated investors whose high-risk appetite is so high that regulatory oversight and protection are unnecessary. An accredited investor should have a particular level of income (i.e., in the US, $200,000 in income over the past two years or $1 million in capital) or a certain level of professional experience, such as holding in good standing a Series 7, 65, or 82 licenses.

2. Exchange Listing and Share Ownership Transfer

Public Companies

Typically, the shares of a public company are listed and traded on an exchange. This allows the owners of a company to be easily transferred since buyers and sellers transact directly with one another in the secondary market.

Each transaction between a buyer and seller causes a change in share price. Such transactions, therefore, can show the changes in the value of companies over time. Moreover, the effect of significant news about a company or the overall economy can affect the value of the shares.

The value of equity (market capitalization) of a listed public company can easily be calculated by multiplying the most recent stock price by the number outstanding.

Market capitalization is the theoretical amount an investor would pay to own an entire company. Realistically, however, the investor will have to add a premium over market capitalization to woo the shareholders into acquisition.

Investors are also interested in the enterprise value of a public company. Enterprise value represents the market value of a company, i.e., the net of cash held by the company. It is calculated as:

$$\text{Enterprise value = Market value of shares + Market value of Debt – Cash}$$

Enterprise value gives a better value of the cost of owning a company that is free and clear of all debt.

Private Companies

In private companies, shares are not listed on an exchange. For this reason, there is no noticeable valuation or price transparency, making it difficult to buy and sell shares. However, if the owner of the private company wants to sell shares, they will have to find a willing buyer and then agree on the price.

For private company shareholders, their investment is locked up either until another company buys the company or it goes public. However, the potential returns earned from investing in private companies are generally higher than those earned from investing in public companies.

3. Registration and Disclosure Requirements

Public Companies

Public companies are obligated to register with a regulatory authority. This implies that they are subject to greater compliance and reporting requirements. For instance, the Securities and Exchange Commission (SEC) regulates US public companies.

Additionally, public companies must disclose certain information, such as a stock transaction made by directors. The disclosed documents are publicized. It is, therefore, easier for investors and analysts to gauge the risks that might affect a company’s business strategy and profit generation or those that might impede the fulfillment of its financial obligations.

Private Companies

Private companies are not subject to the same level of regulatory authority as public companies. Despite that, some pertinent rules such as filing tax returns and prohibitions against fraud are still applicable. It is worth appreciating that, unlike their public counterparts, private companies have no obligation to disclose particular information to the public.

Private companies can willingly disclose important information directly to their investors. This, particularly, happens when there is an objective to raise capital in the future. They are not required to file documents to a regulatory body.

Going from Private Company to Public Company

A private company can go public in three ways: Initial public offering (IPO), direct listing, and acquisition.

Initial Public Offering (IPO)

In this method, a private company that meets certain listing requirements outlined by the exchange completes an IPO. An IPO involves an investment bank that underwrites the sale of new or existing shares. If it goes through, the company is public, and thus its shares are traded on an exchange.

The proceeds from an IPO go to the issuing company, which can then use to capitalize on other investments.

Direct Listing (DL)

Unlike an IPO, the direct listing does involve an underwriter, and no new capital is raised. In a direct listing, the company is listed on an exchange where the existing shareholders sell the shares. A direct listing is beneficial in that it is fast and cost-effective.

Acquisition

A private company may go public when acquired by a large public company. Another way is through a special purpose acquisition company (SPAC). A SPAC is a public company that specializes in acquiring an unspecified company in the future; thus, it is mostly called a “blank check” company.

How do SPACs operate?

SPACs raise capital through an IPO, where proceeds are put in a trust account. The money in the trust account can only be distributed to complete the acquisition or can be returned to the investors after a finite time has elapsed.

Investors in SPACs do not know what the SPAC will buy, but they can speculate from the backgrounds of the SPAC’s executives or comments on social media. When the SPAC finalizes the purchase of the private company, the company goes public.

Life Cycle of Corporations

Whether a company is public or private can be determined by identifying its life cycle stage. The typical life of a company goes from start-up to growth, to maturity, then to decline.

Start-up Stage

At this stage, the company is nothing less than an idea and a business plan initially funded by the founders, and if there is a need for more capital, family and friends may buy ownership or provide loans. Moreover, the business risk is extremely high (hence financing is difficult), the company lacks revenues, and cash flows are negative.

More capital may be required as the company grows. As such, the founders may seek help from an investment banker to raise capital from venture capitalists (series A investors), usually private equity or debt investors.

Growth Stage

At the growth stage, more capital is required, and the revenue and cash flows may be increasing, with moderate business risk. However, the company is not yet profitable and thus cannot rely on internally generated income to facilitate growth. The company might seek capital from the series B and series C capital providers or consider going public via an IPO if it meets the requirements and the owners are willing to let go of the ownership.

Maturity Stage

At this stage, the need for external funding decreases, and the business risk is less. Moreover, the company is profitable with positive and predictable revenues and cash flows and thus can internally fund its growth using retained earnings.

Additionally, the company has a high potential to borrow money at favorable terms from the private or public market since cash flows are more predictable and the operations are “business-as-usual” (BAU).

Decline Stage

At this stage, the need for external financing is decreasing. Moreover, the company may be trying to salvage itself by developing new lines of business or acquiring companies that are growing significantly. As such, business risk is increasing.

As the company is trying to reinvent itself, it may need additional capital, but the costs might be higher, given the declining cashflows; hence financing difficulty is increasing.

Going from Public Company to Private Company

A company can go from public to private when investors (or groups of investors) purchase all the shares of the company and then delist it from the exchange. This can happen through two methods: leveraged buyout (LBO) or managed buyout (MBO).

Both LBOs and MBOs involve borrowing capital to finance the acquisition. The difference between LBOs and MBOs comes with the relationship between the investors buying a company and the acquired company. In an LBO, the investors are not affiliated to the company, while in an MBO, the buying investors are part of the acquired company’s management.

LBOs and MBOs typically occur when investors feel that a company’s shares are undervalued in the public market. Further, they can happen when investors are persuaded that the financing costs of the acquisition are significantly low and attractive.

Trends in Public and Private Companies

In emerging economies, the number of public companies is increasing. This is because there are higher growth rates. Besides, this trend is attributable to the transition from closed to open market structures. The opposite is true for developed economies.

In developed economies, the number of private companies is increasing (an intuitively decreasing public companies) due to the following reasons:

• Mergers and acquisitions.
• Many private companies prefer to be private for easy accessibility of capital from the private market. This is because they can dodge regulatory hampers and associated costs.
• Companies prefer to remain private to discourage the short-term focus most investors in public companies have. Privatization offers flexibility and fruitful decision-making to business leadership.

Question

Which of the following statements is most likely true regarding a corporation at the maturity stage?

1. Revenue and cash flows are positive and predictable.
2. Revenues are positive and predictable, but cashflows are negative and unpredictable.
3. Low potential to source external financing.

Solution

The correct answer is A.

At the maturity stage, a corporation has positive cash flows and revenues. As such, the corporation has a high potential to outsource external financing at reasonable terms because its cash flows are more predictable with business-as-usual operations.