If you're willing to open up ownership to the general public, an initial public offering (IPO) provides an attractive way to obtain capital without relinquishing any operational control over business activities. But as you'll find, this option isn't for everyone.
Before the 2007-2009 global economic crisis, it wasn't uncommon to read about some small company (usually Silicon Valley-based) becoming an overnight success story by deciding to "go public" through an initial public offering (IPO) of its stock. Times have certainly changed in the last few years, but that doesn't preclude your business from an IPO.
The Ins and out of going public
Going public simply means that a company that was previously owned by a limited number of private investors (or maybe even just a sole owner) has elected, for the first time, to sell ownership shares of the business to the general public.
Compelling reasons to go public
Why open up your business ownership to the masses? With the increased ownership from going public, you can generate funds for:
- Working capital
- Repaying debt
- Making acquisitions
- Expanding marketing programs and reach
Basically, anything to help your business grow (anything legal, that is).
Beyond the initial monetary gains, a successful public offering increases the visibility and appeal of your company. And when your popularity rises, the demand and value for shares rises correspondingly.
Going public from the investor's standpoint
Investors can benefit from an IPO for two key reasons:
- The potential increase in market value for their stock usually surpasses that of purchasing stock from a well-established company
- Because stock is more liquid than other forms of ownership (e.g., becoming a partner), investors can sell at virtually any time for any reason
The availability of a public market for shares will also help determine the taxable values of the shares and assist in estate transfers.
Publicly traded stock can make your business more attractive to prospective and existing employees if stock option and other stock compensation plans are offered. Even if you haven't gone public yet, you can still offer shares to prospective and current employees, which, depending on the amount, could be worth a small fortune when your company goes public. Remember that employee stock-based programs are worth more if transfer restrictions, such as those normally accompanying private company stock, are not placed on the stock.
The current state of the IPO
Before 2008, a sizable number of small businesses—many venture capital-funded—felt that reaching an IPO was the epitome of success. Since the economic meltdown, most small companies are not going to go public.
IPOs largely remain a financing option limited to rapidly growing, successful businesses that generate over a million dollars in net annual income. For some perspective on what it takes to achieve an IPO in today's economy, consider these much-publicized recent IPOs:
- When Groupon went public, it employed roughly 7,000 workers and brought in close to $320 million annually in revenue.
- When Facebook filed for its IPO, the social media giant boasted 3,000 employees and was valued at roughly $3.7 billion.
Since going public, Groupon has disappointed analysts and shareholders. Mark Zuckerberg, Facebook's CEO, has repeatedly mentioned his reluctance to go public, citing his fear that public ownership diminishes creativity. And now that Facebook has gone public, Zuckerberg is surrounded by a firestorm of controversy for the IPO.
In this economy, and even in a booming one, it takes a very specific, growth-oriented business to go public.
The limitations of an IPO
An IPO can be many things, but a financial panacea it is not. Yes, an IPO may be the financing solution for your company. But nothing in business is a savior.
Like any financing option, an IPO comes with risks and drawbacks you need to consider:
- The high cost and complexity involved in complying with federal and state laws governing the sale of business securities puts a damper on many small businesses consider an IPO. You can expect to shell out anywhere $50,000—$500,000 taking your company public.
- Offering your business' ownership for public sale does little good unless your company has sufficient investor awareness and appeal to make the IPO worthwhile.
- In addition to the complexity and cost of an IPO, management must be ready to handle the administrative and legal demands of widespread public ownership.
- Of course, an IPO also means a dilution of the existing shareholders' interests and the possibility of takeovers or adjustments in management.
Of course, if you go public, then you'll have to remain in compliance with myriad securities-related laws.
Navigating securities laws
Many federal and state laws regulate the sale of securities. They have two primary objectives:
- To require businesses to disclose material information about the company to investors.
- To prohibit misrepresentation and fraud in the sale of securities.
Under federal law, a security is broadly defined and would include stocks, notes, bonds, evidence of indebtedness and most ownership interests.
Federal law further defines a public offering of a security not by the number of investors who are offered the stock, but by the classification of whether the investors are considered "sophisticated" or not. Sophisticated, here, doesn't refer to your investors who consider themselves wine-and-cheese elitists, but rather investors with enough investing experience to understand the risks and potential rewards of their investments.
However, state law definitions of a "security" and of a "public offering" can vary from the federal law.
Can you bypass securities laws?
Many small businesses can sell stock to insiders or to a small group of investors without being subject to securities laws.
In effect, they can take advantage of alternatives to going public. However, it's not always clear where the exemptions end. That's why we recommend always consulting a knowledgeable attorney before selling any stock in your company, particularly one with intimate knowledge of the state and federal registration statements concerning the securities to be sold, complex disclosure documents about the company with detailed information for potential investors, and financial statements.
Bottom line: Employing professionals (attorneys, accountants and even stock underwriters) to assist in the process is a practical necessity.
Alternatives to going public
If you're like the overwhelming majority of small business owners (especially those not in the tech sector), going public isn't feasible or desirable. Yet you might find the idea of diluting ownership through the sale of stock appealing. To the collective relief of many entrepreneurs, you can sell stock in your company without going public.
While many small businesses sell interests in their companies defined as securities by federal or state laws, these transactions are often exempt from registration regulations because:
- The offerings meet the government's criteria as being sufficiently small in dollar amount
- The available stock is restricted to a limited number and/or type of investors.
These exempt offers of securities are called limited private offering (LPO), and they can avoid much of the cost and delay of a public offering. Unfortunately, to qualify for any of the exemptions, you must fit the criteria for both federal and state security laws.
Qualifying for a limited private offering
Limited private offerings offer the flexibility of being either debt or equity instruments, or a hybrid of both. For instance, you can create a convertible debt warrant, which is simply a formal agreement between you and another party that gives the holder (the other party) the right to buy stock from the issuer (you or your business) at a specific price if acted upon within a certain time frame.
Once the holder is ready to act, he or she can purchase stock in your business in a private setting. Compared to an IPO, this alternative offering allows your business to tailor:
- The amount of immediate equity (ownership and control) you're willing to relinquish
- The amount of debt (cash outflow) that your business can safely assume.
Because virtually all LPOs use equity rather than debt financing, we'll limit our advice to selling equity through LPOs.
Staying in compliance with regulation
To make LPOs worth your time, you'll want to stay within the parameters that allow you to avoid registering your securities with the Securities and Exchange Commission (SEC). Rule 504, commonly known as Regulation D, remains the most popular exemption from registration requirements among small business owners.
Under this provision, private companies selling less than $1 million worth of securities to any number of investors within a 12-month period are exempt from federal registration requirements. You're clearly limited in the amount of securities you can sell; fortunately, Regulation D doesn't drastically restrict how you market the sale of these securities.
Private business can solicit investors through almost any means, including advertisements and seminars, and no specific disclosure requirements regarding the stock or the company are required. Luckily for you and the majority of America's entrepreneurs, most startups and smaller businesses would fall within this exemption.
Even if a securities offer is exempt from the registration requirements of federal or state law, the anti-fraud provisions of those laws may still apply. Take care to prevent misrepresentations or omissions in the offering that create an overly optimistic picture of the investment. The investor should be provided with sufficient information to make an informed decision regarding the investment.
Selling to accredited investors
For small businesses looking to sell more than $1 million in stocks in a 12-month period—or publicly held companies—you'll want to consider limiting stock sales to accredited investors.
This option is available to:
- Private and publicly held companies
- Companies selling less than $5 million within a 12-month period
- No more than 35 accredited investors
While you can sell quite a bit more stock, you have to sell it to quite a limited audience—and quite a specific audience. Accredited investors, as defined by the law, are largely limited to:
- Institutional investors (e.g., banks, brokers and dealers and insurance companies)
- Company insiders (e.g., officers and directors)
- Wealthy investors ("wealthy" defined as a more than $200,000 individual annual income or, individually or jointly with their spouses, having a net worth of over $1 million)
Selling to sophisticated investors and other regulation-exempt strategies
As a public or privately held firm, you do have two more options to sell stocks without registering them as securities.
- For a private or publicly-held company hoping to sell an unlimited issuance of securities to an unlimited number of accredited investors, or to no more than 35 nonaccredited but sophisticated investors (investors with sufficient knowledge and experience to understand the risks of the sale), a lesser degree of exemption from regulation exists.
- You can also find exemption for private offerings of stock sold only to persons living in the same state where your company is both incorporated and does significant business. Be warned: Relying upon this intrastate exemption is subject to continual policing because the securities must remain within the state.
Qualifying for state exemptions
The great thing about multiple levels of government is multiple laws to abide by. Because each state maintains its own securities regulations, you'll need to review your state's statutes and regulations, and perhaps review multiple states if you're selling shares in a state you're not incorporated in. Just because a sale may be exempt from federal registration does not mean state registration is not required.
State securities laws are commonly referred to as "blue sky" laws because the regulations were originally enacted to prevent unscrupulous issuers from selling "speculative schemes that have no more basis than so many feet of blue sky."
The state laws need not match the federal regulatory exemptions. Even though a Uniform Securities Act exists for states to follow, that Act has not been adopted by each state nor is it consistently interpreted in the states which claim to follow it. Like most legal quagmires, a consultation with a qualified professional is a practical necessity before soliciting investors for sales of securities.
Category : Business Finance