Chapter 3

Public or Private: How Company Structure Affects the Books

In This Chapter

Looking at the private side of business

Checking out the public world of corporations

Seeing what happens when a company decides to go public

Not every company wants to be under public scrutiny. Although some firms operate in the public arena by selling shares to the general public on the open market, others prefer to keep ownership within a closed circle of friends or investors. When company owners contemplate whether to keep their business private or to take it public, they're making a decision that can permanently change the company's direction.

In this chapter, I explain the differences between public and private companies, the advantages and disadvantages of each, and how the decision about whether to go public or stay private impacts a company's financial reporting requirements. I also describe the process involved when company owners decide to take their business public.

Investigating Private Companies

Private companies don't sell stock to the general public, so they don't have to report to the government (except for filing their tax returns, of course) or answer to the public. No matter how big or small these companies are, they can operate behind closed doors.

A private company gives owners the freedom to make choices for the firm without having to worry about outside investors’ opinions. Of course, to maintain that freedom, the company must be able to raise the funds necessary for the business to grow — through either profits, debt funding, or investments from family and friends.

Checking out the benefits

Private companies maintain absolute control over business operations. With absolute control, owners don't have to worry about what the public thinks of its operations, nor do they have to worry about the quarterly race to meet the numbers to satisfy Wall Street's profit watch. The company's owners are the only ones who worry about profit levels and whether the company is meeting its goals, which they can do in the privacy of a boardroom. Further advantages of private ownership include

• Confidentiality: Private companies can keep their records under wraps, unlike public companies, which must file quarterly financial statements with the Securities and Exchange Commission (SEC) and various state agencies. Competitors can take advantage of the information that public companies disclose, whereas private companies can leave their competitors guessing and even hide a short-term problem.

  Owners of private companies also like the secrecy they can keep about their personal net worth. Although public companies must disclose the number of shares their officers, directors, and major shareholders hold, private companies have no obligation to release these ownership details.

• Flexibility: In private companies, family members can easily decide how much to pay one another, whether to allow private loans to one another, and whether to award lucrative fringe benefits or other financial incentives, all without having to worry about shareholder scrutiny. Public companies must answer to their shareholders for any bonuses or other incentives they give to top executives. Private-company owners can take out whatever money they want without worrying about the best interests of outside investors, such as shareholders. Any disagreements the owners have about how they disburse their assets remain behind closed doors.
• Greater financial freedom: Private companies can carefully select how to raise money for the business and with whom to make financial arrangements. After public companies offer their stock in the public markets, they have no control over who buys their shares and becomes a future owner.

  If a private company receives funding from experienced investors, it doesn't face the same scrutiny that a public company does. Publicly disclosed financial statements are required only when stock is sold to the general public, not when shares are traded privately among a small group of investors.

Defining disadvantages

The biggest disadvantage a private company faces is its limited ability to raise large sums of cash. Because a private company doesn't sell stock or offer bonds to the general public, it spends a lot more time than a public company does finding investors or creditors who are willing to risk their funds. And many investors don't want to invest in a company that's controlled by a small group of people and that lacks the oversight of public scrutiny.

If a private company needs cash, it must perform one or more of the following tasks:

• Arrange for a loan with a financial institution
• Sell additional shares of stock to existing owners
• Ask for help from an angel, a private investor willing to help a small business get started with some upfront cash
• Get funds from a venture capitalist, someone who invests in start-up businesses, providing the necessary cash in exchange for some portion of ownership

These options for raising money may present a problem for a private company because

• A company's borrowing capability is limited and based on how much capital the owners have invested in the company. A financial institution requires that a certain portion of the capital needed to operate the business — sometimes as much as 50 percent — come from the owners. Just as when you want to borrow money to buy a home, the bank requires you to put up some cash before it loans you the rest. The same is true for companies that want a business loan. I talk more about this topic and how to calculate debt-to-equity ratios in Chapter 12.
• Persuading outside investors to put up a significant amount of cash if the owners want to maintain control of the business is no easy feat. Often major outside investors seek a greater role in company operations by acquiring a significant share of the ownership and asking for several seats on the board of directors.
• Finding the right investment partner can be difficult. When private-company owners seek outside investors, they must ensure that the potential investors have the same vision and goals for the business that they do.

Another major disadvantage that a private company faces is that the owners’ net worth is likely tied almost completely to the value of the company. If a business fails, the owners may lose everything and may even be left with a huge debt. If owners take their company public, however, they can sell some of their stock and diversify their portfolios, thereby reducing their portfolios’ risk.

Figuring out reporting

Reporting requirements for a private company vary based on its agreements with stakeholders. Outside investors in a private company usually establish reporting requirements as part of the agreement to invest funds in the business. A private company circulates its reports among its closed group of stakeholders — executives, managers, creditors, and investors — and doesn't have to share them with the public.

A private company must file financial reports with the SEC when it has more than 500 common shareholders and $10 million in assets, as set by the Securities and Exchange Act of 1934. Congress passed this act so that private companies that reach the size of public companies and acquire a certain mass of outside ownership have the same reporting obligations as public companies. (See the nearby sidebar “Private or Publix?” for an example of this type of company.)

When a private company's stock ownership and assets exceed the limits set by the Securities and Exchange Act of 1934, the company must file a Form 10, which includes a description of the business and its officers, similar to an initial public offering (also known as an IPO, which is the first public sale of a company's stock). After the company files Form 10, the SEC requires it to file quarterly and annual reports.

In some cases, private companies buy back stock from their current shareholders to keep the number of individuals who own stock under the 500 limit. But generally, when a company deals with the financial expenses of publicly reporting its earnings and can no longer keep its veil of secrecy, the pressure builds to go public and gain greater access to the funds needed to grow even larger.

Understanding Public Companies

A company that offers shares of stock on the open market is a public company. Public company owners don't make decisions based solely on their preferences — they must always consider the opinions of the business's outside investors.

Before a company goes public, it must meet certain criteria. Generally, investment bankers (who are actually responsible for selling the stock) require that a private company generate at least $10 million to $20 million in annual sales, with profits of about $1 million.

(Exceptions to this rule exist, however, and some smaller companies do go public.) Before going public, company owners must ask themselves the following questions:

• Can my firm maintain a high growth rate to attract investors?
• Does enough public awareness of my company and its products or services exist to make a successful public offering?
• Is my business operating in a hot industry that will help attract investors?
• Can my company perform as well as, and preferably better than, its competition?
• Can my firm afford the ongoing cost of financial auditing requirements (which can be as high as $2 million a year for a small company)?

If company owners are confident in their answers to these questions, they may want to take their business public. But they need to keep in mind the advantages and disadvantages of going public, which is a long, expensive process that takes months and sometimes even years.

Companies don't take themselves public alone — they hire investment bankers to steer the process to completion. Investment bankers usually get multimillion-dollar fees or commissions for taking a company public. I talk more about the process in the upcoming section “Entering a Whole New World: How a Company Goes from Private to Public.”

Examining the perks

If a company goes public, its primary benefit is that it gains access to additional capital (more cash), which can be critical if it's a high-growth business that needs money to take advantage of its growth potential. A secondary benefit is that company owners can become millionaires, or even billionaires, overnight if the initial public offering (IPO) is successful.

Being a public company has a number of other benefits:

• New corporate cash: At some point, a growing company usually maxes out its ability to borrow funds, and it must find people willing to invest in the business. Selling stock to the general public can be a great way for a company to raise cash without being obligated to pay interest on the money.
• Owner diversification: People who start a new business typically put a good chunk of their assets into starting the business and then reinvest most of the profits in the business in order to grow the company. Frequently, founders have a large share of their assets tied up in the company. Selling shares publicly allows owners to take out some of their investment and diversify their holdings in other investments, which reduces the risks to their personal portfolios.
• Increased liquidity: Liquidity is a company's ability to quickly turn an asset into cash (if it isn't already cash). People who own shares in a closely held private company may have a lot of assets but little chance to actually turn those assets into cash. Selling privately owned shares of stock is very difficult. Going public gives the stock a set market value and creates more potential buyers for the stock.
• Company value: Company owners benefit by knowing their firm's worth for a number of reasons. If one of the key owners dies, state and federal inheritance tax appraisers must set the company's value for estate tax purposes. Many times, these values are set too high for private companies, which can cause all kinds of problems for other owners and family members. Going public sets an absolute value for the shares held by all company shareholders and prevents problems with valuation. Also, businesses that want to offer shares of stock to their employees as incentives find that recruiting with this incentive is much easier when the stock is sold on the open market.

Looking at the negative side

Regardless of the many advantages of being a public company, a great many disadvantages also exist:

• Costs: Paying the costs of providing audited financial statements that meet the requirements of the SEC or state agencies can be very expensive — sometimes as high as $2 million annually. (I discuss the audit process in greater detail in Chapter 18.) Investor relations can also add significant costs in employee time, printing, and mailing expenses.
• Control: As stock sells on the open market, more shareholders enter the picture, giving each one the right to vote on key company decisions. The original owners and closed circle of investors no longer have absolute control of the company.
• Disclosure: A private company can hide difficulties it may be having, but a public company must report its problems, exposing any weaknesses to competitors, who can access detailed information about the company's operations by getting copies of the required financial reports. In addition, the net worth of a public company's owners is widely known because they must disclose their stock holdings as part of these reports.
• Cash control: In a private company, owners can decide their own salary and benefits, as well as the salary and benefits of any family member or friend involved in running the business. In a public company, the board of directors must approve and report any major cash withdrawals, whether for salary or loans, to shareholders.
• Lack of liquidity: When a company goes public, a constant flow of buyers for the stock isn't guaranteed. For a stock to be liquid, a shareholder must be able to convert that stock to cash. Small companies that don't have wide distribution of their stock can be hard to sell on the open market. The market price may even be lower than the actual value of the firm's assets because of a lack of competition for shares of the stock. When not enough competition exists, shareholders have a hard time selling the stock and converting it to cash, making the investment nonliquid.

A failed IPO or a failure to live up to shareholders’ expectations can change what may have been a good business for the founders into a bankrupt entity. Although founders may be willing to ride out the losses for a while, shareholders rarely are. Many IPOs that raised millions before the Internet stock crash in 2000 are now defunct companies.

Filing and more filing: Government and shareholder reports

Public companies must file an unending stream of reports with the SEC. They must file financial reports quarterly as well as annually. They also must file reports after specific events, such as bankruptcy or the sale of a company division.

Quarterly reports

Each quarter, public companies must file audited financial statements on Form 10Q, in addition to information about the company's market risk, controls and procedures, legal proceedings, and defaults on payments.

Yearly report

Each year, public companies must file an annual report with audited financial statements and information about

• Company history: How the company was started, who started it, and how it grew to its current level of operations
• Organizational structure: How the company is organized, who the key executives are, and who reports to whom
• Equity holdings: A list of the major shareholders and a summary of all outstanding stock
• Subsidiaries: Other businesses that the company owns wholly or partially
• Employee stock purchase and savings plans: Plans that allow employees to own stock by purchasing it or participating in a savings plan
• Incorporation: Information about where the company is incorporated
• Legal proceedings: Information about any ongoing legal matters that may be material to the company
• Changes or disagreements with accountants: Information about financial disclosures, controls and procedures, executive compensation, and accounting fees and services

In addition to the regular reports, public companies must file an 8-K, a form for reporting any major events that can impact the company's financial position. A major event may be the acquisition of another company, the sale of a company or division, bankruptcy, the resignation of directors, or a change in the fiscal year. A public company must report any event that falls under this requirement on the 8-K to the SEC within four days of the event's occurrence. I discuss the rules for SEC Form 8-K in greater detail in Chapter 19.

The rules of the Sarbanes-Oxley Act

All the scandals about public companies that emerged in the early 2000s have made this entire reporting process riskier and more costly for company owners. In 2002, Congress passed a bill called the Sarbanes-Oxley Act to try to correct some of the problems in financial reporting. This bill passed as details emerged about how corporate officials from companies like Enron, MCI, and Tyco hid information from the SEC.

New SEC rules issued after the Sarbanes-Oxley Act passed require CEOs and CFOs to certify financial and other information contained in their quarterly and annual reports. They must certify that

• They've established, maintained, and regularly evaluated effective disclosure controls and procedures.
• They've made disclosures to the auditors and audit committee of the board of directors about internal controls.
• They've included information in the quarterly and annual reports about their evaluation of the controls in place, as well as about any significant changes in their internal controls or any other factors that could significantly affect controls after the initial evaluation.

If a CEO or CFO certifies this information and that information later proves to be false, he or she can end up facing criminal charges. Since the passage of the Sarbanes-Oxley Act, companies have delayed releasing financial reports if the CEO or CFO has any questions rather than risk charges. You'll probably hear more about delays in reporting as CEOs and CFOs become more reluctant to sign off on financial reports that may have questionable information. Shareholders often panic when they hear about a delay, and stock prices drop.

The Sarbanes-Oxley Act has added significant costs to the entire process of completing financial reports, affecting the following components:

• Documentation: Companies must document and develop policies and procedures relating to their internal controls over financial reporting. Although an outside accounting firm can assist with the documentation process, managers must be actively involved in the process of assessing internal controls — they can't delegate this responsibility to an external firm.
• Audit fees: Independent audit firms now look a lot more closely at financial statements and internal controls in place over financial reporting, and the SEC's Public Company Accounting Oversight Board (PCAOB) now regulates the accounting profession. The PCAOB inspects accounting firms to be sure they're in compliance with the Sarbanes-Oxley Act and SEC rules.
• Legal fees: Because companies need lawyers to help them comply with the new provisions of the Sarbanes-Oxley Act, their legal expenses are increasing.
• Information technology: Complying with the Sarbanes-Oxley Act requires both hardware and software upgrades to meet the internal control requirements and the speedier reporting requirements.
• Boards of directors: Most companies must restructure their board of directors and audit committees to meet the Sarbanes-Oxley Act's requirements, ensuring that independent board members control key audit decisions. The structure and operation of nominating and compensation committees must eliminate even the appearance of conflicts of interest. Companies must make provisions to give shareholders direct input in corporate governance decisions. Businesses also must provide additional education to board members to be sure they understand their responsibilities to shareholders.

Entering a Whole New World: How a Company Goes from Private to Public

So the owners of a company have finally decided to sell the company's stock publicly. Now what? In this section, I describe the role of an investment banker in helping a company sell its stock. I also explain the process of making a public offering.

Teaming up with an investment banker

The first step after a company decides to go public is to choose who will handle the sales and which market to sell the stock on. Few firms have the capacity to approach the public stock markets on their own. Instead, they hire an investment banker to help them through the complicated process of going public. A well-known investment banker can lend credibility to a little-known small company, which makes selling the stock easier.

Investment bankers help a company in the following ways:

• They prepare the required SEC documents and register the new stock offering with the SEC. These documents must include information about the company (its products, services, and markets) and its officers and directors. Additionally, they must include information about the risks the firm faces, how the business plans to use the money raised, any outstanding legal problems, holdings of company insiders, and, of course, audited financial statements.
• They price the stock so it's attractive to potential investors. If the stock is priced too high, the offering could fall flat on its face, with few shares sold. If the stock is priced too low, the company could miss out on potential cash that investors, who buy IPO shares, can get as a windfall from quickly turning around and selling the stock at a profit.
• They negotiate the price at which the stock is offered to the general public and the guarantees they give to the company owners for selling the stock. An investment banker can give an underwriting guarantee, which guarantees the amount of money that will be raised. In this scenario, the banker buys the stock from the company and then resells it to the public. Usually, an investment banker puts together a syndicate of investment bankers who help find buyers for the stock.

  Another method that's sometimes used is called a best efforts agreement. In this scenario, the investment banker tries to sell the stock but doesn't guarantee the number of shares that will sell.

• They decide which stock exchange to list the stock on. The New York Stock Exchange (NYSE) has the highest level of requirements. If a company wants to list on this exchange, it must have a pretax income of at least $10 million over the last three years and 2,200 or more shareholders. The NASDAQ has lower requirements. Companies can also sell stock over the counter, which means the stock isn't listed on any exchange, so selling the stock both as an IPO and after the IPO is much harder.

Making a public offering

After the company and the investment banker agree to work together and set the terms for the public offering, as well as the commission structure (how the investment banker gets paid), the banker prepares the registration statement to be filed with the SEC.

After the registration is filed, the SEC imposes a “cooling-off period” to give itself time to investigate the offering and to make sure the documents disclose all necessary information. The length of the cooling-off period depends on how complete the documents are and whether the SEC asks for additional information. During the cooling-off period, the underwriter produces the red herring, which is an initial prospectus that includes the information in the SEC registration without the stock price or effective date.

After the underwriter completes the red herring, the company and the investment bankers do road shows — presentations held around the country to introduce the business to major institutional investors and start building interest in the pending IPO. A company can't transact sales until the SEC approves the registration information, but it can start generating excitement and getting feedback about the IPO at these meetings.

When the SEC finishes its investigation and approves the offering, the company can set an effective date, or the date of the stock offering. The company and investment bankers then sit down and establish a final stock price. Although they discuss the stock price in initial conversations, they can't set the final price until they know the actual effective date. Market conditions can change significantly from the time the company first talks with investment bankers and the date when the stock is finally offered publicly. Sometimes the company and investment banker decide to withdraw or delay an IPO if a market crisis creates a bad climate for introducing a new stock or if the road shows don't identify enough interested major investors.

After the stock price is set, the stock is sold to the public. The company gets the proceeds minus any commissions it pays to the investment bankers.