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Who wants to go public, anyway?

For decades, the conventional wisdom on the public offering’s place in a firm’s lifecycle has been a rather linear story. As a company matures and its capital expenditure needs increase over time, it can afford – and thus take advantage of – raising funds in public capital markets. The first time a company sells equity to the public is known as an initial public offering, or IPO. The intuition behind this theory of IPO decision-making was rather simple; federal securities laws – via gun-jumping rules and onerous disclosure requirements – made the public offering process itself a rather expensive and time-consuming endeavor. ((See 15 U.S.C. § 77e.)) Furthermore, the listing of a company on a national exchange triggered continuing disclosure requirements that would be similarly costly and subject the firm to increased risk of securities fraud litigation under the SEC’s Rule 10b-5. ((See 15 U.S.C. § 78a; 17 CFR § 240.10b-5.)) With these high-cost barriers to entry to the public markets, it was theorized that only firms later in the growth cycle, with greater capital expenditure needs and access to sufficient corporate treasuries, could afford going public. Once they cleared that milestone, however, they would theoretically have access to a lower cost of capital due to the greater liquidity in public markets.

Yet evidence from the last two decades has cast significant doubt on the conventional wisdom for going public. Since 2000, the average number of IPOs per year in the United States dropped sharply compared to the period from 1980 to 2000. ((See Gao, et. al., Where Have all the IPOs Gone?, 58 J. Fin. And Quantitative Analysis 1663, 1663 (Dec. 2013).)) Some have attributed this to increasing regulatory complexity for public companies, especially the enactment of the Sarbanes-Oxley Act in 2002 ((Id.)) and later, the Dodd-Frank Reform Act in 2010. However, the regulatory burden hypothesis does not tell the full picture: the decline in IPOs began well before major public company reform legislation in the early 2000s. ((See Elizabeth de Fontenay, The Deregulation of Private Capital and the Decline of the Public Company, 68 Hastings L.J. 445, 465 (2017).))

Mounting evidence suggests that while conditions in the public market have changed relatively little – that is, they have remained costly to access at the outset – deregulation of the private capital markets has transformed the public offering from a necessary evil for later-stage growth companies to just a good-ole fashioned evil. ((See id. at 445.)) Prior to the deregulation of private capital raises, restrictions on to whom offers for securities could be made and mandatory holding periods for private equity choked off a secondary market for private capital. The effect was to keep the cost of capital in private stocks higher relative to the public markets, where the SEC’s mandatory disclosure regime ensured greater flow of information. However, the enactment of Regulation D, which made it easier to make offers for private securities, as well as the expansions of Rule 144 and Rule 144A, which lifted certain resale restrictions, vastly enhanced the liquidity of the secondary market, bringing down the cost of capital. ((See id. at 468.)) With comparably cheap capital available in the private capital markets, companies could now seek funding without the financial and administrative headaches of being a public company.

This new paradigm raises an important question: if comparatively priced, adequate funding can be obtained in the private markets without the additional expense associated with a public listing and public company status, why go public at all? One theory is that the shrinking pool of IPOs is indicative of the declining quality of the firms that make the decision to go public; later-stage firms might make the decision to go public only when their efforts to raise money from private markets begin to plateau. ((Vikramaditya S. Khanna, William W. Cook Prof. of L., Uni. Mich. L. Sch., Securities Regulation Lecture, (Nov. 29, 2018).)) Since private markets tend to be dominated by repeat players and “smart money” investors, the concern is that lower quality firms are being forced into the public markets, creating a quasi-“market for lemons” in the IPO market. ((Id.)) Empirical data on the issue is inconclusive. For instance, evidence suggests that public firm investment levels are slightly lower than their similarly matched private firm counterparts, but the finger is pointed at the ex post pressures of short-termism, rather than own-firm decline. ((John Asker et. al., Corporate Investment and Stock Market Listing: A Puzzle?, 28 Rev. Fin. Stud. 342, 342 (2014).))

Others have posited that the IPO is transforming into a means for unlocking founder value – that is, providing opportunity for founders and other long-term equity owners to cash out in the public markets. ((See de Fontenay, supra note 5, at 459.)) The latter view in particular casts doubt on conventional theories on the IPO’s place in a firm’s growth cycle. It conceives of the public-private dimension as a choice, rather than purely a function of size, sophistication, and need. ((Id. at 478.)) This has profound implications for firms, investors, and regulators alike – although it will take some time to fully grasp the scope of this new paradigm’s impact on contemporary capital markets, it is quite clear that the old model doesn’t quite fit.

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Ali N. Habhab

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