I found an interesting article which suggests that funding from public equity markets may not be the optimal decision for companies.
Investors are generally very wary of private companies and this is expected given the risks, uncertainty and lack of information surrounding private equity markets. For more information on private equity see the post titled Private Equity Investment.
There is a general perception that raising capital via public equity is more cost effective than private equity. Since the returns associated with private equity have historically been higher than public equity returns, this is a reasonable view. However, Moon (2006) suggests that this may not always be the case and sometimes the benefits of using private equity as financing outweigh the benefits of public equity. Since the publication of this paper in 2006, the private equity market has grown substantially.
Listed companies are considered as having more credibility and financial flexibility than unlisted ones. An initial public offering (IPO) represents financial success and is a milestone that most companies strive to achieve. If we take Automattic (WordPress) as an example, Matt Mullenweg decided not to go public and raise funds from the private equity market instead. Some may consider Automattic as being more credible and financially flexible than some listed companies.
Listed companies are subject to substantial direct costs of raising capital in public markets. Indirect costs, which could potentially be much larger than direct costs, are sometimes not accounted for. Indirect costs can be as a result of the following events:
- Announcements of seasoned equity offerings
Research has shown that this causes on average a 3% drop in the company’s stock price and in some extreme cases the drop can be as high as 10% (Moon, 2006). Theoretically, equity offerings should not result in a decline in the value of a company’s shares. It should actually signal new investment opportunities that require funding within the company and this should result in the stock price increasing. Obviously, this isn’t the case with all companies but on average there is a negative reaction to equity offerings.
- Public investors are very wary of where they invest their funds. As mentioned by Andrew Canter from Old Mutual, complex companies with intricate business plans will find it difficult and more expensive to raise capital in public equity markets (and private equity markets).
- During times of financial hardship and uncertainty, investors grow skeptical and demand a higher return for their investments. If the company is willing to meet the demand of investors, this may send a negative signal to the market which in turn leads to more skepticism. On the other hand, when the company has adequate cash flows and financial times are good, funding from public equity markets is more affordable.
So, in a nutshell, equity funding is readily available during economic upturns when listed companies may not actually require it. However, it is expensive in economic downturns where investments may be attractive but funds are limited. So do listed companies really have financial flexibility as opposed to private companies?
The decision to list a company should not be taken lightly and it is important to ensure that listing your company is more beneficial than remaining private.
Moon, J. J. 2006. Public vs. Private Equity*. Journal of Applied Corporate Finance. 18(3): 76-82.