Perspectives on going public

A study of 200 family businesses in Europe, Asia, and the United States reveals how owners see the pros and cons of selling stock on the open market and the best time to do it.

By Monica Wagen

Going public is a move fraught with risk for many family business owners. Yet a surprising number have done it, greatly benefiting both their companies and their families. In the United States, initial public offerings have been popular with owners and investors in the last year, and they are on the rise in Europe. Thus it is a good time to review the risks and rewards. Going public can be an excellent way to raise capital, provide a way for shareholders to cash out, and attract top managers. However, it can virtually eliminate privacy, limit managementÕs power, even set the table for a takeover.

Owners who are thinking about going public must confront some difficult tradeoffs. These were described by respondents to a recent study I completed of 200 owners, managers, and successors of family businesses from 20 countries, ranging in size from 20 to 2,000 employees. Respondents from Europe, Asia, and the United States provided extensive written comments about the major advantages and disadvantages of going public, as well as the best time to do so. Their views are summarized here. While they present primarily a European viewpoint, there is remarkable agreement among respondents from the various continents on the greatest risks and rewards of going public

 

Easier capital, more liquidity

The survey respondents had all traveled to the International Institute for Management Development in Lausanne, Switzerland, for a seminar entitled ÒLeading the Family Business.Ó Of them, 12.5 percent had gone public, primarily to raise capital. Another 27.5 percent had considered going public, but ended up not taking action because there was no financial need for it or because the market was not ready. The remaining 60 percent had not considered the option.

More of these owners will grapple with selling stock in the near future, however. A considerable 25 percent said they would issue shares within the next 10 years, and another 43 percent indicated they might issue shares.

Owners who had gone public or indicated they would issue shares cited considerable advantages. Once stock is listed on a stock exchange owners have a vehicle for selling shares in order to raise capital for the company, or cash for themselves. Often owners sell shares in small, successive lots as needed, while retaining enough shares to continue to control overall management. The opportunity to finance growth with equity rather than debt convinced many owners to offer stock to the public. The additional working capital enabled them to capture more market share, launch a new product, update technology, or overcome a recession.

There are two ways for a private company to go public. The first is to issue for sale a portion of the existing stock already held by shareholders. This does not increase the companyÕs liquidity, but it does provide shareholders with cash, and gets stock out onto the market. The second method is to issue additional shares, increasing the capital of the company by the amount outsiders pay for the new shares. This can bring a number of benefits.

Marketability of shares. Shares of stock held in a private company have limited marketability. Going public creates a market in which those shares can be easily sold. Furthermore, because there is an outlet, banks and other lenders are much more willing to allow family members to use their stock as collateral for a loan. Respondents noted that creating a public market also gives family members who are not working for the company a way to convert their shares into cash, at a predictable price, from time to time. (Some owners drafted agreements that limit how many shares can be sold during a certain time period, so that family control and the stock price do not change too drastically.) Designing two different classes of stockÑvoting and nonvotingÑcan ensure that the family retains voting power over the company.

Solution for inheritance tax. Families rarely have the private wealth to pay estate taxes once an owner dies. The burden usually falls to the company, and efforts to raise the money often drain the company treasury and imperil its future. By creating a public market, owners can raise the funds for estate taxes by selling shares at the right time.

Increasing the companyÕs value. Once stock is issued publicly, its price may increase remarkably. Outside investors are much more willing to pay a higher price for the stock of a public company than for a private one because of the marketability of the shares, the credibility attributed to public firms, and the openness of a public companyÕs financial records.

Cheaper capital. Selling shares on the open market is the equivalent of borrowing money that does not have to be paid back immediately. This improves the companyÕs financial position. It may also enable the company to borrow money at more attractive interest rates. Moreover, respondents who had successful IPOs indicated they were able to raise additional capital in subsequent offerings under even more favorable conditions. The cycle enables a continued infusion of capital, an improved balance sheet, and increased borrowing power. A public market also provides a way for owners to acquire companies; owners can sell shares to raise cash for a purchase, or offer stock directly to the owners of another company in exchange for their firm.

Manager incentives. Stock incentives can be key to attracting and retaining top nonfamily managers. While shares in a privately held company can engender a healthy sense of ownership in employees, there are usually limited opportunities to cash out. Creating a market for the shares makes the incentive much greater; it also eliminates pressure on family members and the company to buy back shares from departing executives. WhatÕs more, outsiders view companies with public shares as more willing to accept nonfamily executives at senior levels.

Increased prestige. One of the advantages of going public that was widely recognized by respondents is greater corporate visibility and prestige. If a family company is well run and compiles a record of success, going public will usually widen the name recognition of its products and services, as well as the publicity they receive. Both customers and investors often prefer to do business with well-known companies.

Many family companies have gone on to international fame after completing a public offering. Examples include Benetton in Italy, Peugeot in France, BMW in Germany, Hoffmann-LaRoche in Switzerland, Kikkoman in Japan, and Marriott in the United States. These companies all went public to sustain growth and to give owners greater flexibility in their degree of involvement with the firm.

 

Less privacy and control

For all its potential benefits, going public involves several potential negatives.

Loss of privacy. Respondents indicated that the most disturbing change that occurs when a company sells stock is the lost privilege of being discreet. The companyÕs financial position, the identity of its shareholders, and the degree of confidentiality enjoyed by owners and shareholders will change significantly. The salaries, incentives, and perquisites for family executives will become public information. Documents that contain highly sensitive information, such as sales figures or the salaries of directors, will have to be revealed to public shareholders and regulators as a matter of course, or upon request.

Possible takeovers. If a company issues too many shares, an investor, entrepreneur, or competitor can wrest control from the owners. Family owners should retain enough shares so they can continue to elect the companyÕs directors and determine corporate actions. If more than 50 percent of the stock will be distributed, the family can try to retain control by selling the shares widely in small lots, but this entails risk; an investor can buy up shares and mount a takeover campaign. As an alternative, family owners can issue only nonvoting stock for public purchase. However, these shares appeal somewhat less to investors and therefore usually command a lower price.

Changes in board structure. If an investment banker takes a company public, he or she may expect a seat on the board of directors. Although not law in Europe, it is usually required by the bank, which sees board membership as the best way to assure timely access to company information and to exert some control over decisions. The practice is less prevalent in the United States. Although the family may view this as an erosion of control, the bankerÕs expertise often contributes greatly to the firmÕs success. Having the person on the board generally advances the companyÕs new status as well.

Limitation of power. Simply put, the company will suddenly have outsiders who have a say in its operation. Shareholder meetings will be more formal and complicated. Approval of the board and consent of shareholders will be needed on specific matters. Changes in ownership structure or policy, such as a stock split or a decrease in dividends, will also have to be made public.

Perhaps the greatest risk, however, will come from shareholdersÕ desire for income. They will generally judge managementÕs performance in terms of dividends, profits, and stock price, and will apply pressure to increase dividends and earnings each quarter. If the family is not careful, this may cause management to emphasize short-term goals instead of long-term strategies.

Increased costs. The initial cost of going public is substantial. The underwriterÕs commission, legal fees, printing costs, registration expenses, and audit expenditures can represent as much as 10 percent of the offering price. Key executives noted that once the move was made, they had to devote a surprising amount of time to informing shareholders and the public and to preparing reports, diverting their attention from daily operations. It may also be necessary to update the companyÕs accounting system so it can produce financial information in a timely manner that is in keeping with the standards of the stock exchange and its regulators. If complex reporting requirements are not accurately fulfilled, executives could be subject to various legal liabilities, such as charges of creating false or misleading reports.

 

Where and when to go public

Deciding to go public is one challenge. Actually doing it is another. The two big questions are where to issue stock, and when.

It is much easier for large companies to go public than medium-sized ones. The legal formalities are less well designed for placing medium-sized family businesses on a stock exchange. Furthermore, taxation, regulations, and administrative requirements for admission to the biggest stock exchanges have been drawn up for large companies; their complexities and costs are highly dissuasive for medium-sized firms. Medium-sized companies will do much better by first joining over-the-counter markets or regional stock exchanges, both of which can be very productive.

Investors tend to look for companies with several years of strong, steady growth and rising profits. To them, these numbers indicate managementÕs ability to compete over the long run. An owner should issue stock only after the company has established such a track record, or the response will likely be small. Some investors also will not consider investing in an IPO unless the company can anticipate very significant growth over the next few years.

Even if a company satisfies these criteria, however, market conditions might not be propitious at the time the company wants to place its offer. The market for initial public offerings has varied significantly, from the depressed levels of the mid-1970s to the record highs of the mid-1980s. Political developments, interest rates, the rate of inflation, and economic forecasts all influence the mood of the investment community.

There is no sign of a slowdown in IPOs in the United States this year. Market analysts predict there will be renewed interest in going public in Europe in the near future, particularly as inheritance and succession issues arise in family firms. Family businesses that have a success record and future potential, a need or desire for capital and liquidity, and a willingness to lose some privacy and control might find it an optimum time to consider going public.


Monica Wagen is a research associate at the International Institute for Management Development in Lausanne, Switzerland. She is a lawyer and holds an MBA and DBA.