IPO Basics: Benefits, Risks, and Alternatives

Do you know which company was the first to go public in the world? It was the Dutch East India Company, founded in 1602, marking the birth of the concept of going public. Since then, listing has become a standard feature of the financial market. However, for those not involved in finance or investing, the term "listing" may be unfamiliar. In this article, we will explore the different methods of listing, the associated risks, and how companies respond to these challenges.

There are a few things you must know about going public. Going public is when a previously private company places its shares on an exchange, making them publicly available for trading in the market.

Why Companies Choose to go Public?

1. One of the main reasons is financing

   When a company goes public, it actually raises funds by issuing new shares, a process called a financing listing.

   
   

   The benefits of financing and listing are mainly reflected in two aspects:

   Companies can raise funds by selling new shares, which provides financial support for business expansion and development.

   
   

   Going public enables a company's shares to be traded on the public market, providing investors with a platform to buy and sell shares.

   
   

   Some people may think that going public is just to make money and cash out. This may be a bit biased. To put it more professionally, going public is a financing method and one of the main reasons why many large companies choose it. Generally speaking, by issuing new shares in the public market, companies are actually seeking financial support to enable them to operate and develop better.

   
   

   It can be understood through an example. For example, a milk tea shop is going to be listed. Before going public, A was the 100% controlling shareholder of this company. Assume that the company is valued at 10 billion, and before going public, A chooses to dilute 50% of the shares and issue 100 million new shares at 100 yuan per share. In this way, if B, C, and D want to buy shares in Xiaolin Milk Tea Shop, they can buy them at a price of 100 yuan per share, thus raising 10 billion yuan for the company. At this time, the company's valuation is $20 billion, and A only holds 50% of the shares. The funds raised can be used for the company's future development.

   
   

2. The second important reason for listing is to cash out

   Before the company goes public, the founding team and early investors hold shares in the company. If A is a founder and owns 100% of the shares of the milk tea shop, it is actually quite difficult for A to cash out these shares before the company is listed.

   
   

   Of course, Person A can try to find someone to sell the shares, but it is not easy to find someone willing to pay a reasonable price to buy them. Because the other party may not know A, nor is he familiar with the milk tea shop, and he lacks trust in A. In this way, even if A lowers the price, it may not be able to successfully sell the shares, the liquidity will become poor, and the transaction cost will be high.

   
   

   Once the company goes public, the situation is completely different. A's shares become easier to cash in, and transaction costs are reduced accordingly. In short, listing makes it easier for Person A to sell his shares for cash; that is, it is easier to cash out. This means that A’s shares become more liquid, and transaction costs are reduced accordingly, making the entire cash-out process smoother.

   
   

   Financing and making money are actually related to the company, but the benefit of cashing out is more relevant to early founders or early shareholders. In the past two decades, especially with the rapid development of the Internet, the value of shares held by early teams has become quite powerful.

   
   

   We often hear that programmer friends around us joined the early team of an Internet company and then achieved financial freedom as the company developed rapidly. Take ByteDance programmer Guo Yu as an example. He joined ByteDance in 2014 or 2015. At that time, the company may not have had that much cash, but it provided options worth about 500,000. Unexpectedly, in five or six years, the value of these options increased nearly 200 times. Guo Yu announced his retirement at the age of 28. Such success stories are not uncommon.

   
   

   But you also need to be cautious when cashing out. If all stocks are sold as soon as they are listed, the stock price is bound to fall sharply. For this reason, early investors usually set a period called a "lockup period" when the company goes public, during which the shares cannot be sold, usually ranging from a few months to two years. Moreover, the shareholding information of the company's major shareholders is public, and their behavior will receive great attention because it reflects their confidence in the company's future development.

   
   

   The founding team needs to be extra cautious when selling shares, as this may cause panic in the outside world. When a major shareholder of a company starts selling shares, there is usually a flurry of criticism on the forum, so you need to take into account the company's image and external reactions when making decisions and be cautious and prudent.

   
   

3. The reputational effect brought about by the company’s listing

   This doesn’t just sound good; it’s of huge value to companies, especially consumer-facing T&C companies. When a company goes public, the word has a halo effect, giving the company greater credibility in the minds of consumers. When consumers are shopping, they see an unfamiliar brand. Once they know that it is a listed company, they will think that it is a big company and will be less likely to deceive them, so they will be more willing to buy. In addition, going public not only has a halo effect on the company but also on the company's executives. When you introduce a friend, if you can say that this is the CEO of a listed company, your friend will think that this person is very powerful.

   
   

4. Reduce the cost of refinancing

   After a company is listed, if it wants to continue to develop, it usually needs to continue to raise funds, which may be loans from banks or issuing shares or bonds in the secondary market. For a listed company, its borrowing costs will be greatly reduced because its maturity, credibility, and information disclosure have been recognized. Let’s take the milk tea shop as an example. If the milk tea shop is a listed company, when borrowing money from a bank, the bank may give you a better interest rate for the sake of the listed company. For another example, for a large company with an extremely high credit rating like Walmart, the cost of borrowing may be equivalent to or even lower than the interest rate on U.S. Treasury bonds. This means that the company has an advantage in terms of funds, which reduces the cost of refinancing. Going public not only brings more money but also improves the company's reputation. Early teams can more easily cash out, and the cost of refinancing is also reduced accordingly.

Why do some large companies choose not to go public?

1. Avoid dilution

   Many large companies choose not to go public, such as Dassault and Huawei, because there is a very large cost for the company or the founding team, which is the dilution of equity. For example, before the milk tea shop goes public, Person A has 100% control and can make whatever decisions he wants. But after the listing, after shareholders like B, C, and D join, A must consider their opinions when formulating development strategies and no longer has complete decision-making power. What's worse is that not only do they lose autonomy in development decisions, they may even be squeezed out of the company. Just like the potato chip brother, the founder of Lululemon, whom we mentioned before, after the company went public, capital operations in the public market went back and forth, and his voice weakened, and he was eventually even voted out of the company. Therefore, the main reason why some founders choose not to go public is to maintain control of the company and avoid dilution of their equity.

   
   

2. A company's listing requires the disclosure of a large amount of information

   Since there are many public investors after listing, in order to ensure the safety of their investments, the company's financial information must be fully disclosed. There is a quarterly report every quarter and an annual report every year, which must also detail the company's future prospects and development strategies. In most cases, companies may not be willing to make all information public because it may involve the company's business secrets, development plans, etc. But if it is not written, investors may feel that the company has no plan, and the stock price may fall. Therefore, listed companies need to balance information disclosure with the protection of trade secrets.

   
   

   However, information disclosure is not necessarily a bad thing. For example, JD.com’s listing is mainly for the purpose of disclosing information. Why should we disclose information? There were too many rumors at the time. There were always rumors that JD.com’s capital chain was about to break, and JD.com had many suppliers. Once it broke, the suppliers would be affected. Liu Qiangdong considered that on the one hand, he wanted to clarify the rumors, but on the other hand, he also knew that even if he clarified, some people would always say that he was trying to cover up the capital chain problem, so he simply went public and made the financial information public so that suppliers could feel at ease.

   
   

3. Time and Money Cost

   In addition to equity dilution and information disclosure, going public also involves direct costs in time and money. In terms of time, generally speaking, it takes one to one and a half years to go public in the United States, while in China, the listing process may be longer, even three or four years. This is a huge project. Some companies have announced that they will go public next year, and you can feel that the amount of work behind this is huge.

   
   

   In terms of costs, going public usually requires finding an investment bank. Investment banks will first take away some fees. For example, if a small company wants to raise $1 billion, the investment bank may take away $100 million to $200 million. In addition, the company also needs to hire lawyers and accountants to prepare for the entire listing, which will also involve a lot of expenses. Therefore, if there are not tens of millions in the account, it is basically difficult to complete this task.

   
   

   The requirements for listing are also very strict. It does not mean that a company that spends time and money will be able to successfully go public. There is still a risk of failure to go public. Generally speaking, when listing, there are certain requirements for the company's profit performance. For example, Nasdaq may have specific requirements on cash flow, assets, or income, while the requirements for A-shares are more stringent. A-shares require companies to make profits when listed, which is one of the reasons why many Internet companies choose not to be listed on A-shares. Because Internet companies need a lot of financing from the beginning and invest a lot of money to accumulate users and traffic, almost none of them, including many Internet companies in the United States, are profitable when they go public. Of course, profit requirements are only one of them.

Why do Tech Giants List in the U.S. and Hong Kong?

One reason is time to market. Listings in the United States generally use a registration system, while China uses an approval system, although China has recently gradually transitioned to a registration system. So, what is the difference between the registration system and the approval system? The registration system means that the company prepares materials and submits them to the China Securities Regulatory Commission, and after approval, they can be registered and listed. But the approval system is different. The China Securities Regulatory Commission will first review the materials and then conduct an in-depth review of the company after confirming that they are correct, which will make the entire process longer. And whether it can eventually be listed on the market is completely decided by the China Securities Regulatory Commission, and the company can only wait.

Early Internet companies usually rely on funds from institutional investors, but these investors have already withdrawn their investment. Who would be willing to wait another three or four years? These Internet companies will also introduce overseas investors or US dollar funds, which is very important in There may be problems when the stock goes public. Therefore, these reasons have led many Internet giants to choose to list in Hong Kong or the United States.

What are the Costs and Risks of Going Public?

Not only are there costs in the listing process, but the maintenance costs are also huge. Because information needs to be disclosed after listing, such as quarterly reports and annual reports, what costs does this bring? These materials need to be prepared, and listed companies not only need to prepare their own financial reports but also need to ask an audit firm to conduct an audit. They can only be released after passing the review. After the financial report is released, a press conference needs to be organized to disclose this information. The company also needs to respond to questions from the popular media, Wall Street analysts, and others. To deal with these, companies need to have a dedicated investor relations (IR) department to organize the entire process, answer questions, and maintain relationships. These later maintenance costs need to be taken into consideration.

In addition to the obvious costs of going public, there is also a huge hidden cost: the company will be subject to the hijacking of Wall Street and short-term interests. Because the stock price of listed companies attaches great importance to development speed, once growth slows down or profits decrease, the stock price may plummet. This forces company management to work hard to make each quarter's results look better to meet the stock market's expectations. The company may originally develop with long-term goals, but after going public, it is more likely to be driven by short-term interests. The executive compensation of most companies is directly linked to the stock price, which has also led to unreasonable increases in executive compensation. Therefore, listed companies may face some costs that cannot be ignored in their long-term development.

Management tends to pay more attention to the short-term performance of the company because it may be hijacked by short-term interests. Once short-term benefits cannot be realized, there may even be some fraud and forgery, just like Enron. Enron initially made some fine-tuning to make its performance look better but ended up falling into an abyss, eventually leading to the bankruptcy of Lehman Brothers.

Public companies also need to cater to Wall Street and maintain a good relationship with it. Why? Because when ordinary investors buy stocks, they usually pay more attention to the news and the opinions of Wall Street analysts rather than delving into the company's financial development strategy. If the company has to face negative reviews from Wall Street, the stock price could fall. This not only affects the short-term stock price but also has a more profound impact on the company's long-term creditworthiness and borrowing costs. As the public's expectations of the company decrease, the company's creditworthiness and borrowing costs will increase, and the capital chain may be broken, which will have a significant impact on the company. Therefore, in order to maintain their reputation, listed companies need to spend energy maintaining good relations with Wall Street.

Risk Management for Going Public

1. Build a risk management team

   Responsible for monitoring and responding to various risks to ensure that the company can respond in a timely manner.

   
   

2. Conduct regular risk assessments

   Evaluate various risks within and outside the company and formulate corresponding risk management plans.

   
   

3. Establish a crisis management plan

   Develop a detailed crisis management plan for possible emergencies, including response measures and communication strategies.

   
   

4. Investor Relations Management

   Establish good investor relations, communicate with investors regularly, provide accurate and timely information, and respond to investors’ concerns.

   
   

5. Legal compliance training

   Provide legal and compliance training to employees to ensure they understand relevant regulations and company policies and reduce regulatory compliance risks.

   
   

6. Develop a financial strategy

   Establish clear financial goals and strategies to ensure the company has adequate financial stability.

   
   

7. Build a resilient supply chain

   Build resilience in supply chain management to reduce the risk of business disruption due to supply chain issues.

   
   

8. Regularly assess the competitive environment

   Conduct regular competitive analysis to understand market dynamics and adjust company strategies to adapt to changes.

Ways to Go Public

1. Initial Public Offering (IPO)

   Once a company decides to go public, the most common method is to conduct an initial public offering (IPO). The company raised funds from the public by issuing shares, introducing its shares to the securities market for the first time. Before an IPO, companies typically hire teams of investment banks and lawyers to help them with the offering process. But the cost and time of an IPO are considerable, so many companies are reluctant to choose this path.

   
   

2. Direct listing (DPO)

   A direct listing is a relatively new method in which a company raises capital by listing on a stock exchange without having to issue new shares or wait too long. Companies can trade their shares directly on the public market instead of raising capital by issuing new shares. Spotify, Slack, and Coinbase have all chosen direct listings.

   
   

3. Reverse Merger

   This method involves an already-public company (a shell company) acquiring a private company and turning it into a public company. This reverse merger method can introduce the company to the securities market more quickly than the traditional IPO process.

   
   

4. Special Purpose Acquisition Company (SPAC)

   A SPAC is a company formed specifically for the sole purpose of acquiring other companies, making them indirectly public. SPACs raise money through an IPO and then find a private company to merge with within a certain period of time. This approach is known as a "blank check company." This method is simpler than the IPO process and reduces time and money costs, but it also comes with some risks. Litigation cases regarding SPACs have also increased in the past two years, so there are certain risks to this approach. For example, Jia Yueting’s Faraday Future was listed through SPAC.

   
   

5. Secondary Listing

   Some companies may, after listing on their original stock exchange, decide to list on other exchanges to further expand their investor base and market influence.

From the various ways to go public, risks, and countermeasures, we can understand that going public is an important way for companies to obtain funds and improve credibility, but it is also accompanied by a series of costs and risks. Companies need to clearly consider their own needs and future development plans when making decisions.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.