Comparing Public and Private Financing

Advantages of Public Financing

The main advantage in seeking public financing is that it offers a larger pool of funding for the company than private financing alone.

Learning Objectives

Discuss why a company may want to go public

Key Takeaways

Key Points

  • The magnitude of funding available from public financing is its chief advantage.
  • An initial public offering is when a private company converts to a public company by selling shares of its stock publicly.
  • A company can sell further shares of stock in secondary offerings.
  • A company can also sell debt, in the form of bonds, in public exchanges.

Key Terms

  • security: proof of ownership of stocks, bonds, or other investment instruments.W

Public Company Definition

A publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating over the counter markets..

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Public Financing: Public financing offers immediate access to large amounts of funding.

Main Advantage of Public Financing

Usually, security of a publicly traded company is owned by many investors while the shares of a privately held company are owned by relatively few shareholders. Therefore, publicly traded companies are able to raise funds and capital through the sale (in the primary or secondary market) of their securities, whether debt or equity, to a wide range of buyers. This is the reason publicly traded corporations are important; prior to their existence, it was very difficult to obtain large amounts of capital for private enterprises. The magnitude of funding available from public financing is its chief advantage.

Advantages from Initial Public Offering

New companies, which are typically small, tend to be privately held. After a number of years, if a company has grown significantly and is profitable or has promising prospects, there is often an initial public offering, which converts the privately held company into a publicly traded company.

Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, to monetize the investments of early private investors, and to become publicly traded enterprises.

When a company lists its securities on a public exchange, the money paid by the investing public for the newly issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a portion of their holdings (secondary offering) as part of the larger IPO. An IPO, therefore, allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of debt, or working capital. A company selling common shares is never required to repay the capital to its public investors.

An IPO accords several benefits to the previously private company:

  • Enlarging and diversifying equity base
  • Enabling cheaper access to capital
  • Increasing exposure, prestige, and public image
  • Attracting and retaining better management and employees through liquid equity participation
  • Facilitating acquisitions (potentially in return for shares of stock)
  • Creating multiple financing opportunities, such as equity, convertible debt, and cheaper bank loans

Advantages from Follow-On Offering

Once a company is listed, it is able to issue additional common shares in a number of different ways, one of which is the follow-on offering. This method provides capital for various corporate purposes through the issuance of equity without incurring any debt. This ability to quickly raise potentially large amounts of capital from the marketplace is a key reason many companies seek to go public.

Advantages of Private Financing

Private financing can enhance a firm’s capital structure, save on costs, and improve managerial incentive alignment.

Learning Objectives

Describe why a company may want to go private

Key Takeaways

Key Points

  • One advantage of private financing is that private investors may infuse the company with more capital than was available to it from public financing.
  • Private financing also saves on administrative costs of being a publicly traded company.
  • Private financing can improve incentives for management, and increase investor involvement.

Key Terms

  • incentive: Something that motivates, rouses, or encourages.
  • Stock: The capital raised by a company through the issue of shares. The total of shares held by an individual shareholder.
  • investor: A person who invests money in order to make a profit.

Definition

In countries with public trading markets, a privately held business is generally taken to mean one whose ownership shares or interests are not publicly traded. Often, privately held companies are owned by the company founders or their families and heirs or by a small group of investors. Sometimes employees also hold shares of private companies. Most small businesses are privately held.

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Private financing: Private financing can offer advantages over public.

Going Private

Though most companies start out privately held, there are situations in which a publicly traded company becomes privately acquired. This means that a small group of investors purchases all outstanding shares of the company. The company is then privately financed. This transition it known as “going private. ”

Advantages

There are several advantages to private financing:

  • Increased capital: Sometimes going private results in a significant injection of capital, because the investors are willing to buy the company’s stock at a higher price than it is trading on the market. They are willing to pay more in order to privately control the firm.
  • Administrative costs: It is possible for the company to save administrative costs. Being a publicly traded company entails administrative costs, such as annual reports, registration with regulating bodies, and communicating with shareholders. A privately financed company does not have these costs.
  • Managerial incentives: In many instances it is the management which takes over and privately controls the company. In this case, they have a more immediate incentive to improve the company’s performance, because they are investors as well.
  • Investor involvement: A publicly traded company’s shareholders are a large, anonymous, and mostly uninformed group. They do not typically know the business, much less the daily operations, of the company and are not in a good position to be productively involved with it. Private investors, on the other hand, can offer expert knowledge, and direct oversight of the company in a way that can benefit performance.
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1903 stock certificate of the Baltimore and Ohio Railroad: Normally stocks are traded publicly, except in the instance of private stocks, which are only offered and traded by internal stakeholders such as founders, employees, etc.

Types of Private Financing Deals: Going Private and Leveraged Buyouts

LBOs use debt to secure an acquisition and the acquired assets service the debt.

Learning Objectives

Define a leveraged buyout

Key Takeaways

Key Points

  • The acquiring party borrows money in addition to using its own funds to meet the purchase price of the target. LBOs can also occur to public companies, such as in public to private (PtP) transactions.
  • The term typically applies to a deal in which a financial sponsor acquires a company. In this instance, the sponsor uses debt to increase its return on equity.
  • LBOs are appealing to the acquiring company because debt typically carries a lower cost of capital than equity, which means that by employing more debt, the acquiring party magnifies returns.

Key Terms

  • overleveraged: Subject to excessive leverage
  • insolvency: The condition of being insolvent; the state or condition of a person who is insolvent; the condition of one who is unable to pay his debts as they fall due, or in the usual course of trade and business; as, a merchant’s insolvency.
  • leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

Definition of Leveraged Buyout

A leveraged buyout (LBO) is an acquisition (usually of a company, but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt, and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with the increasing debt. The debt thus effectively serves as a lever to increase returns, which explains the origin of the term leveraged buyout (LBO).

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Financing deal: An LBO is a type of financing deal.

Forms of LBOs

LBOs are a very common occurrence in today’s Mergers and Aquisitions environment. The term LBO is usually employed when a financial sponsor acquires a company. However, many corporate transactions are part-funded by bank debt, and thus also effectively representing an LBO. LBOs can have many different forms, such as Management Buyout (MBO), Management Buy-in (MBI), and secondary buyout and tertiary buyout, among others. They can occur in growth situations, restructuring situations, and insolvencies just like in companies with stable performance. LBOs mostly occur in private companies, but can also be employed with public companies (in a so-called PtP transaction, Public to Private).

Common Cause of LBOs

As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition. This has, in many cases, led to situations in which companies were “overleveraged”, meaning that they did not generate sufficient cash flows to service their debt. In turn, this then led to insolvency or to debt-to-equity swaps, in which the equity owners lose control over the business and the debt providers assume the equity.

Characteristics

LBOs have become attractive, as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending. The amount of debt banks which are willing to provide and support an LBO varies greatly and depends on the quality of the asset to be acquired–stability of cash flows, history, growth prospects, and hard assets; the amount of equity supplied by the financial sponsor; and the history and experience of the financial sponsor.

Debt Ratio

For companies with very stable and secured cash flows, debt volumes of up to 100% of the purchase price have been provided. In situations of “normal” companies with normal business risks, debt of 40–60% of the purchase price are normal figures. The debt ratios that are possible also vary significantly between the regions and industries of the target. Depending on the size and purchase price of the acquisition, the debt is provided in different tranches:

  • Senior debt: This debt is secured with the assets of the target company and has the lowest interest margin
  • Junior debt: This debt usually has no securities and bears a higher interest margin