Is It Time for Companies to Go Private?Published: August 14, 2002 in Knowledge@Wharton
Sure, the stock market is deep in the dumps. But the silver lining in today’s weak economy is low interest rates. Shouldn’t that make it easier for young companies – and established ones, too -- to find cash, even if they can’t sell stock? Indeed, there has been some speculation that increasing numbers of public companies, unable to raise money in the equity market, might reverse course and go private, while private companies might elect to stay that way -- not by necessity but by choice.
Can conditions really have turned upside down? It was only a few years ago that going public as soon as possible seemed to be the goal of just about every young company. Certainly, there are some attractions to going private, or staying that way, says Raphael H. Amit, professor of entrepreneurship and management at Wharton. “In many cases, going public is a liability,” he notes. “My advice is not to go public too early, because it will be very difficult for you to recover if you hit a bump.”
Private companies are forced to satisfy impatient shareholders quickly, even if the best strategy is to go slow, he says, and the cost of meeting Securities and Exchange Commission reporting requirements can be high. While it can be cheaper to raise money as a public company issuing stock, if market conditions preclude this option it can pay to stick with the greater flexibility available to a private firm.
In a May story headlined We Don’t Need No Stinking IPOs!, BusinessWeek magazine cited some small companies that had elected to stay private for just these reasons. And earlier this month the magazine noted that Martha Stewart might try to take her public company private. But those cases are hardly typical. The IPO-rejecting firm cited by BusinessWeek was profitable enough to attract private backers, while many small companies are not. And Stewart, who already holds a controlling interest in her firm, could acquire the other shares cheaply because of the insider-trading investigations aimed at her sales of another company’s stock have driven down her company’s price.
Indeed, there’s little evidence the public-to-private option is catching on. Thomson Financial, a data provider on public and private companies, says 26 public companies have announced plans this year to go private. While that pace beats the full-year total of 24 in 2001, it’s about the same as the 46 announced in 2000 – and even that was a small number.
It is true that the number of IPOs has fallen dramatically. There have been only 66 this year, compared to a peak of 849 for all of 1996, Thomson says. But most experts say companies are being shut out of the IPO by market conditions; they are not avoiding it by choice. With stock prices down, small companies that can’t issue public shares might be expected to tap the private equity markets. And, with interest rates at near-record lows, companies that can’t sell stock might be expected to raise cash by selling debt or borrowing from banks and other lenders. But it’s not quite that easy
Plenty of private equity is on hand – an estimated $50 billion to $100 billion in venture capital alone, according to Andrew Metrick, a finance professor at Wharton. “That’s more than was put into venture capital for the 20 years prior to 1998,” he says.
But the young company going this route pays a very high price, because private equity essentially works the same way public equity does. When equity prices are low, a company has to sell more shares to raise a given sum. Issuing more shares dilutes the value of shares issued previously. Since private equity is not as liquid as public equity, investors demand a premium – more shares at a lower price. For a small company whose shares are privately held, that can mean giving up too much of future profits, perhaps even losing control. Hence, there is a deep reluctance to tap this market. “Generally, if you have a choice, you don’t go to private equity,” Metrick says. “Private equity is where you go if you don’t have a choice.”
Moreover, although venture capital and other private equity firms are sitting on lots of money, they have become very conservative about investing it, says Ayako Yasuda, a finance professor at Wharton. Typically, private investors plan to stick with a company for five or six years and then realize their profits by selling their shares to the public. But with the IPO market shut down by low stock prices, private investors worry they won’t be able to cash out later.
“Supply of private equity and public equity are positively correlated, as one might expect,” Yasuda says. “When public equity markets are booming, private equity investors find it easier to exit their investments. They can do this via IPO or acquisition by a bigger firm, so they are willing to invest more. The opposite is true during stock market downturns. So right now it is much harder to obtain private equity financing than a couple of years ago.”
Why not borrow? The two ways to borrow are by issuing debt – bonds – or going to a lender such as a bank.
Borrowing has never been much of an option for young high-risk companies, especially for tech firms that have few assets to offer as collateral. But now borrowing can be difficult even for the more established company, despite the appeal of low interest rates. “Unfortunately, investor sentiment has cooled down for corporate bond markets as well, as the stock market crashed, and the environment remains difficult for corporate bond markets” Yasuda says. With so many companies in trouble, corporate bond defaults are expected to set records this year. In a flight to safety, bond investors have turned to U.S. Treasury certificates.
Banks, too, have become conservative and are worried that borrowers will default on loans, she says. “If firms did not have any existing relationships with banks before the market crash, it would be hard for them to get new financing from banks, as banks also tighten their overall portfolios.”
How, then, can a company fund research, development and other projects? One method is the more careful use of retained earnings. In fact, says Yasuda, retained earnings have long been the main capital source for new projects. Smart companies will concentrate on only the most promising projects. Another approach, says Amit, is through mergers. Some companies are sitting on money raised in the 1990s but are stuck with products for which there is now no market. Increasingly, such companies are merging with others that are cash-poor but have viable products. “We see a lot of this activity these days,” he says. “That’s something that companies are very aggressively pursuing.”
While money from equity, debt and loans is indeed tight, this many not be as damaging to the economy as one might think, Metrick says. “A big chunk of the companies that were funded over the past few years are just quietly going out of business,” he says, adding that hard data on this won’t surface for another year or two. But many of these companies were only funded because of the stock bubble of the 1990s, he says. In a more rational market, they would not have been, and it makes sense for these weak firms to expire now.
Truly promising companies are likely to find money from the many cash-rich venture capital firms or other sources, even in today’s market, he says. Amit agrees that the tight money problem has restored some “rationality to the marketplace”. He cautions, however, that innovation and entrepreneurship could be badly damaged if current conditions persist for two or three more years. “I don’t think that things will turn around very fast,” he says.