Why Do Companies Go Public?

Why companies go public

Let’s look at the example of Best Coffee Shop, where owners Natalie, Ethan, and Lauren want to take their business to the next level. They want to expand and grow the company’s earnings by creating 10 new stores in different locations.

Opening up 10 new stores requires $100,000, $10,000 for each store.  Now, how are they going to get the $100,000? 

There are 2 primary options:

1. Borrowing money by getting a $100,000 loan from a bank. This option is not ideal for the owners of Best Coffee Shop since they would have to pay off their bank debt on a preset schedule with interest. Moreover, if the new stores aren’t profitable or it takes them longer to reach profitability, it would be very risky to decide to get a loan from a bank.
2. The second option is to create new shares of stock and sell them to new investors. Such action could raise the needed $100,000. There are upsides and downsides of going public. The upside of selling new stock is that the money doesn’t have to be paid back. However, the downsides are that there are going to be more investors splitting the company’s profits and the original owners no longer own 100% of the business.

Since Natalie, Ethan, and Lauren decide to go for the second option —going public and creating new stock shares to sell to investors, they hire investment bankers who suggest that the new public investors would be willing to buy 10,000 shares at $10 each. This would provide the 3 original owners the $100,000 they need. Natalie, Ethan, and Lauren agree to the terms and take their company, Best Coffee Shop, public. 

Before going public Natalie owned 60%, Ethan owned 30% and Lauren owned 10%.

However, Best Coffee Shop created 10,000 new shares of stock and sold them to public investors. This action changed the ownership of the company’s equity for each of the owners. 

After going public, Natalie still owns 6,000 shares, but her ownership position has been reduced to 30%. Ethan still owns 3,000 shares, but his ownership position has been reduced to 15%. Lauren still owns 1,000 shares, but her ownership position has been reduced to just 5%.

The downsides of taking a company public are that there are going to be more investors to split the company’s profits and the original owners will no longer own 100% of the business. Currently Natalie, Ethan, and Lauren own only half of Best Coffee Shop due to an effect called dilution.

Dilution occurs when a company creates more shares, which lowers the ownership percentage of the company’s existing stockholders. And here is how the ownership of the Best Coffee Shop changed. Nevertheless, Best Coffee Shop gets the $100,000 that it needed to expand and build 10 new stores!

Here’s how the ownership of the Best Coffee Shop Changed:

As you can see, raising money was the reason for Best Coffee Shop to go public, however there are more reasons for companies to go public and sell their stock. These include:

1. Raising money to expand, grow, invest and pay off debt. 
2. Existing owners selling their stock.
3. Making buzz and becoming more visible, getting attention from media, potential investors and new customers.

Depending on their reasoning, when private companies sell new shares of stock to public investors there is an Initial Public Offer (IPO). The shares are traded on a public stock exchange such as the New York Stock Exchange or London Stock Exchange, to name a couple.

Why do investors buy a company’s stock?

All investors across the globe have one simple reason to buy stock – they want to make money. There are two ways for investors to make money while owning stock: capital gains and dividends.

• Capital gains

Capital gain is the first way to make money. Investors buy stock for one price and then sell it at a higher price. This is possible when a stock goes up in value and price over time. It is called appreciation, when the value of an asset like a stock increases over time.

Let’s say that Alison, a public investor, buys stock in Best Coffee company at the Initial Public Offer (IPO) for $10 per share. Brad doesn’t buy at the Initial Public Offer, but he is interested in becoming a shareholder. He is willing to pay $15 per share for the stock and turns out Alison gladly sells her stock to Brad for $15. As you can see, initially Alison bought the stock for $10 per share but thanks to the appreciation of the stock she sold it for $15 per share, meaning she earned $5 per share from  her investment, which means a 50% return on investment. Such a way of making money is called a capital gain.

• Dividends

The second way for public investors to make money with stock is through dividends. Dividends are paid out to shareholders as a cash payment with the purpose of sharing some of a company’s earnings.

Dividend stock

A dividend stock is a company that pays a dividend to its shareholders. Not every company chooses to pay dividends to its shareholders. It is also common for a company’s management to decide to keep the profit within the business and use it internally.

So, imagine that Best Coffee Shop earns $20,000 in earnings and wants to pay out all of that money by paying dividends to its shareholders. Let’s find out how much of the $20,000 profit each shareholder will get.

To find it out, we need to divide the total dividend payment by the total number of shares. This means that each of the public investors will get paid out $1.00 per share in dividends.

Then, we have to multiply the result by the number of shares that each investor owns. In this case, in our example, Natalie receives $6,000, Ethan gets $3,000, and Lauren gets $1,000.

Since the original owners of the company own 50% of the stock, in total they get $10,000 which is half of the $20,000 profit made by their company. Public investors, who own the other half of the stock, get the other half of the company’s profit which is $10,000. All of the share owners, whether the original owners or the public investors, get a $1.00 dividend per share.

Stock Market 101 is a series of videos and articles meant to help you take first steps in investing with understanding and clarity. Read the next part all about valuing a business.