Private Placements v.s. Public Offerings
This paper is about the advantages and disadvantages of Private Placements v.s. Public Offerings. It was written by Mr. Laurie E. S. Talbot, BBA Management and Information Systems, Pace University, NY.
» Step 1
Financial Markets are governed by a set rules, regulations and choices. The choices you make can become a major determinant in your acquisition of finances and degree of profitability. Therefore understanding the differences, advantages, disadvantages, degree of flexibility, speed, convenience and cost to your company will enable you to make critical decisions as to whether you should choose Private Placements or Public Offerings. Some other factors to consider before making a concrete decision are time, yield-to-maturity, interest rates, degree of risk, the Venture Capitalists and even the financial parlance.
Access to capital through private placements is faster than a public offering but in spite of market conditions, micro-cap and small cap companies find it exceedingly intricate to raise capital through public offering. A Private Placement entity is any type of business that is not publicly traded on a listed exchange such as NASDAQ or the New York Stock Exchange (NYSE). Private Placements normally fall into the category of limited partnerships, limited liability company (LLC), limited liability partnership (LLP), C-Corporation/Private Stock or Land Trust.
There are two basic types of Private Placements, Traditional and Structured. Traditional Private Placements are typically arranged through investment banking firms where these firms serve as placement agent and they normally offer better terms for companies. Structured private placements permit the investor to gain if the stock price rises and are protected if the stock price decreases. This means that within the structured arrangement there is a reset mechanism which allows the investor to acquire more shares of the company’s stock if the share price drops. Private Placements frequently dilute the holdings of existing shareholders while the reset mechanism increases the dilution (loss in existing shareholders’ value in terms of either ownership, market value, book value or EPS) further and stock prices continues to decline. The company’s capability to attract additional financing in the future can be severely hindered by the reset mechanism. Private Placements or private equity investing are usually long term loans provided by a limited number of investors.
Advantages of Private Placements
Some of the peculiar features of private placements are as follows. The costs of Securities and Exchange registration can be avoided by direct long-term loans. The direct placements are likely to have more limiting covenants. Private Placement loans are usually easier to renegotiate in the event of default as opposed to public issues which are harder to renegotiate because they are usually too many shareholders involved. In the private placements segment of the bond market the dominant forces are life insurance and pension funds. Private placements in public equities can be funded very quickly. Finally the costs of distributing bonds are lower in the private market. Other very important aspects to consider before making an investment are the fact that interest rates on term loans and private placements are usually higher than on an equivalent public issue. The yield to maturity on private placements according to one study was .46 percent higher than on similar public issues. The obvious substitution of higher interest rates for more elastic provisions in the event of financial distress and the lower costs of private placements make investment in private placements worthwhile. It is also necessary to know that flotation costs associated with selling debt are much less than the equivalent costs linked with selling equity.
Disadvantages of Private Placements
Private Investments in Public Equities investors are not usually long term investors because they are more interested in share price, trading volume and market capitalization. Traditional private placements usually take four to six months to negotiate and close a transaction. Private placements with strategic investors requires protracted due diligence, valuation issues, with often little regard given to the share trading price and frequent desire for strategic investors wanting to become active investors rather than passive investors. Institutionally placed private placements requires prolonged due diligence and strong negotiations regarding terms including frequent board representation and valuation issues which often does not take into consideration the share trading price.
Private Placement financing strategies basically fall into the following four categories; Investments in Public Equities, traditional private placements with an investment banking firm as placement agent, private placements with strategic investors as the investors and institutional placed private placements.
Private Placements in Your Self Directed IRA
Not very many Americans realize that they have the option to self direct their IRA’s to invest in private entities because they have the perception that their IRA investment options are bank CDs or the stock market. For the private entity investor or someone trying to diversify their retirement portfolio, the combination of private entities with your self directed IRA is a very good package. Traditionally, investments in private placements entities have been the backbone for American economic growth. Microsoft and Intel were both private entities that grew into leaders of the American business setting.
» Step 2
Initial Public Offering is the first equity issue of a company that is made available to the public. Public Offerings are also referred to as unseasoned new issue and IPO. These types of issues occur when a company decides to go public by offering the company’s securities to the public. This offering is considered public because it is made to investors outside the group of founders. This process takes about six months and primarily involves the preparation of a prospectus which is filed with the Securities and Exchange Commission of each province in which the IPO is going to be undertaken. The Initial Public Offering is the most noticeable type of Wall Street financing. In 1997 $43 billion was raised via IPOs in the United States. Two of the major hurdles in the IPO market are size and return. The average size underwritten by Merrill Lynch so far was $81 million while investment banks had an average of $50 million. IPO investors require minimum returns of 10 to 15 percent. Because the IPO market is highly cyclical, an IPOs success is dependent on the market conditions. According to investment banks and investors, achieving economies of scale is a determinant for success.
The tax code plays a significant role in shaping the capital structure of American businesses and investor prototypes. The increase in estate tax exemption to $1 million from $600,000 in the year 2006 and the recent reduction in capital gains taxes were much needed changes. Because the tax code continues to favor debt, there is a lot more to be done.
Advantages of Public Offerings
There are several reasons why companies go public. The primary reason businesses go public is to have access to capital. This capital does not have to be repaid and does not involve an interest charge. IPO investors usually receive a reward for their investment and dividends. Small businesses go public because it is not difficult to acquire capital for future needs through new stock offerings and public debt offerings. A peculiar advantage of IPO’s allows small business owners and venture capitalists opportunities to cash out on their early investment. Shares of these types of equities can be sold as part of the IPO in a special offering or on the open market sometime after the IPO. This must never be viewed as a bail out by the owners. Secondly, IPO’s promotes public awareness for small businesses which ultimately creates new opportunities and new customers. The IPO process requires that information about the company must be printed in newspapers across the country, business owners must be aware of the laws covering disclosure of information.
Thirdly, Public Offerings involve the ability to use stock in creative incentive packages for management and employees. Small businesses offer shares of stock and stock options as part of a compensation package to lure better management talent and in order to increase employee motivation. Finally, Public Offerings provide a public valuation of a small business which makes easier for the company to enter into mergers and acquisitions by offering stock rather than cash.
Disadvantages of Public Offerings
Two of the main disadvantages of public offerings are Costs and Time. The IPO process may take as long as two years and requires the small business owner and other top managers to prepare registration statements for the Securities and Exchange Commission, consult with investment bankers, attorneys, and accountants, and take part in the personal marketing of the stock. For this reason many small businesses exist. Secondly, IPO’s are extremely expensive and small businesses normally pay between $50,000 and $250,000 to prepare and publicize an offering. According to Paul G. Joubert author of “The Portable MBA in Finance and Accounting,” small business owners should expect the cost of an IPO to reduce their profits from the sale of stocks by 15 and 20 percent. These costs includes the lead underwriter’s commission; out-of-pocket expenses for legal services, accounting services, printing costs, and the personal marketing by managers; .02 percent filing costs with Securities and Exchange Commission; fees for public relations to bolster the company’s; plus ongoing legal, accounting, filing, and mailing expenses. It is necessary to consider other potential problems that may divert the IPO before the sale of the stock takes place.
Public Offerings have some more disadvantages which involves the company’s loss of confidentiality, flexibility and control. The Securities and Exchange Commission policy stipulates that public companies must release all operating particulars to the public including susceptible information about their markets, profit margins and future plans. Original owners normally dilute the holdings of the company before going public to erode the management control over diurnal operations. This also reduces the flexibility of management due to the fact that it is not possible to make decisions quickly and efficiently when the board has to approve all decisions.
Public Offerings must perform strongly in the short-term because earnings are reported quarterly, and shareholders and financial markets would like to see good results.
The Process of Public Offerings
The first step for a small business going public is selecting an underwriter to act as a mediator between the company and the capital markets. According to Paul G. Joubert, “small business owners should solicit proposals from a number of investments, investment banks, and then evaluate the bidders on the basis of their reputation and experience with similar offerings, experience in the industry, distribution network, record of post-offering support, and type of underwriting arrangement.”
There are three types of underwriting agreements. Best efforts, which means that the investment bank does not commit to buying any shares but agrees to put forward its best effort to sell as many as possible. Secondly, all or none, the offering is canceled if all the shares are not sold and firm commitment, which means that the investment bank purchases all the shares itself. For small businesses the firm commitment agreement is probably the best since the underwriter bears the risk of not selling the shares.
» Step 3
The Venture Capital Industry
Venture Capitalists are investors who make investments in young, rapidly growing companies that show development potential of expanding into significant economic distributors. Venture Capital Firms are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors and the Venture Capitalists themselves. The operations of Venture Capitalists are usually financing new and progressive companies; purchasing equity securities; assisting in the development of new products or services, adding value to the company through active involvement; taking higher risks with anticipation of higher rewards; and having a protracted orientation.
Investment Focus of Venture Capitalists
Venture Capitalists are considered to be Generalist or Specialist investors depending on their investment strategy. Those that are Generalists invest in a mixture of industry sectors or a range of geographic locations, or a choice of stages of a company’s life. Those that are Specialists, invest in one or two industry sectors, or may seek to invest only in a localized geographic area. Venture Capitalists possibly will invest before there is a real product or company organized which is called “seed investing.” Venture Capitalists may provide capital to start up a company in its first or second stages of development known as “early stage investing.” Finally the Venture Capitalist may supply needed financing to help a company grow further than a vital mass to develop into a more thriving company which is referred to as “expansion stage financing.”
Access to capital in America is good. However, the present regulatory and tax structure persists in support of bank and debt financing and should be replaced with policies that offer balanced support for all types of financing. The choice between Private Placements or Public Offerings is entirely individualistic.
1. Fundamentals of Corporate Finance, fourth edition, by Ross, Westerfield and Jordan.
2. Equity Financing Strategies for Micro-Cap and Small-Cap Publicly Traded Companies, by Friedland Capital Inc. Two Worldwide Plaza, 350 West 50th Street, New York, NY 10019.
3. Initial Public Offerings - http://en.wikipedia.org/wiki/Initial_public_offering
4. The Venture Capital Industry – An Overview - http://www.nvca.org/def.html
5. The View From Wall Street, by Nassos Michas
6. Laurie Talbot, Student, BBA Management & Information Systems, Lubin School of Business, Pace University, New York, NY 10038, firstname.lastname@example.org