Reading: Why Go Public?

• Ownership dilution and loss of control: As new shareholders join, the ownership stake of the founders is diluted and founders might even lose control. This could have various implications, including:
  • Loss of private benefits of control: The founders might no longer be able to extract private (financial and nonfinancial) benefits of control such as the use of corporate resources and the prestige that comes with being the owner-manager of a firm.
  • Loss of motivation: It could also be that the management team feels less committed to the company, as it is no longer "their" company.
    
    
• Management incentives:
  • Along similar lines, it could be that it becomes more difficult to incentivize members of the (original) management team.
  • The reason is that IPOs often bring significant financial wealth to these managers. When having such wealth, it is not always clear that people maintain their focus and work equally hard as before the IPO.
  • At the same time, the fact that "insiders" sell their shares could be interpreted as bad news by the new shareholders, as it could signal overvaluation or the previously discussed lack of commitment.
  • To address these challenges, the shares of executives and large investors are often subject to so-called "lock-up provisions" which prohibit the sale of shares over the first 90 - 180 days after the IPO.
    
    
• Expensive dealing with new shareholders
  • Whereas privately held firms often only have a small number of shareholders (most of which are represented on the board of directors), the shareholder base of publicly traded companies is much more anonymous and potentially stretches around the globe.
  • Communicating with shareholders therefore becomes less direct and more costly.
  • Firms have to invest in investor relation services to make sure they adhere to the disclosure and information requirements of the exchange. 
    
    
• Increasing information asymmetry
  • The change in the shareholder base also increases the information asymmetry between the shareholders and the management.
  • The new shareholders are often small outside shareholders who have little incentive to collect their own information about the firm, simply because that would be too costly.
  • Often, the investing public relies on the work of financial analysts, who therefore become an important new stakeholder group of public companies.
  • Financial analysts, however, tend to focus on performance metrics such as earnings per share (EPS) that are relatively easily observable and comparable across companies and over time. As a result, firms also shift their focus towards these metrics, even though they might be only loosely correlated with long-term value creation.
    
    
• Managerial myopia
  
  • The preceding challenge is often compounded by the fact that most public companies have to prepare quarterly financial reports.
  • As a consequence, analysts (and the investing public) formulate quarterly expectations for the key performance metrics and firms exert a great deal of effort to meet these expectations and avoid surprises.
  • The result management could be more myopic. They could forego long-term projects as well as vital activities such as R&D, whose impact on the next quarter's EPS is almost impossible to predict.
    
    
• Disclosure of valuable information
  • In addition, publicly traded firms have to disclose "material" information to their shareholders.
  • According to the U.S. Supreme Court (1982), material information covers "those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.”
  • By disclosing that information, they also make it available to current and potential competitors. 
  • Being publicly traded therefore also implies that competitors learn more about the firm, its strategy, and its financial situation.

Taken together, the above considerations imply that it becomes increasingly difficult for listed firms to engage in NEW activities. Structures and processes become increasingly complex and firms tend to shift their focus to managing their core business efficiently.

In fact, several studies document a drop in innovation after the IPO, along with the observation that many innovative people leave because they do not want to operate in bureaucratic structures.

While these indirect costs might not be clearly visible at the time of the IPO, they can have far-reaching implications for the medium- to long-term success of the firms.