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The Financial Reporting Benefits and Disadvantages of Public Companies

A company that offers shares of stock on the open market is a public company, and will have different financial reporting requirements than a private company. Public company owners don't make decisions based solely on their preferences — they must always consider the opinions of the business's outside investors.

Before a company goes public, it must meet certain criteria. Generally, investment bankers require that a private company generate at least $10 million to $20 million in annual sales, with profits of about $1 million.

(Exceptions to this rule exist, however, and some smaller companies do go public.) Before going public, company owners must ask themselves the following questions:

  • Can my firm maintain a high growth rate to attract investors?

  • Does enough public awareness of my company and its products or services exist to make a successful public offering?

  • Is my business operating in a hot industry that will help attract investors?

  • Can my company perform as well as, and preferably better than, its competition?

  • Can my firm afford the ongoing cost of financial auditing requirements?

If company owners are confident in their answers to these questions, they may want to take their business public. But they need to keep in mind the advantages and disadvantages of going public, which is a long, expensive process that takes months and sometimes even years.

Companies don't take themselves public alone — they hire investment bankers to steer the process to completion. Investment bankers usually get multimillion-dollar fees or commissions.

The perks

If a company goes public, its primary benefit is that it gains access to additional capital (more cash), which can be critical if it's a high-growth business that needs money to take advantage of its growth potential. A secondary benefit is that company owners can become millionaires, or even billionaires, overnight if the initial public offering (IPO) is successful.

Being a public company has a number of other benefits:

  • New corporate cash: At some point, a growing company usually maxes out its ability to borrow funds, and it must find people willing to invest in the business. Selling stock to the general public can be a great way for a company to raise cash without being obligated to pay interest on the money.

  • Owner diversification: People who start a new business typically put a good chunk of their assets into starting the business and then reinvest most of the profits in the business in order to grow the company. Selling shares publicly allows owners to take out some of their investment and diversify their holdings in other investments, which reduces the risks to their personal portfolios.

  • Increased liquidity: Liquidity is a company's ability to quickly turn an asset into cash. People who own shares in a closely held private company may have a lot of assets but little chance to actually turn those assets into cash. Selling privately owned shares of stock is very difficult. Going public gives the stock a set market value and creates more potential buyers for the stock.

  • Company value: Company owners benefit by knowing their firm's worth for a number of reasons. If one of the key owners dies, state and federal inheritance tax appraisers must set the company's value for estate tax purposes. Many times, these values are set too high for private companies, which can cause all kinds of problems for other owners and family members.

    Going public sets an absolute value for the shares held by all company shareholders and prevents problems with valuation. Also, businesses that want to offer shares of stock to their employees as incentives find that recruiting with this incentive is much easier when the stock is sold on the open market.

The negative side

Regardless of the many advantages of being a public company, a great many disadvantages also exist:

  • Costs: Paying the costs of providing audited financial statements that meet the requirements of the SEC or state agencies can be very expensive — sometimes as high as $2 million annually. Investor relations can also add significant costs in employee time, printing, and mailing expenses.

  • Control: As stock sells on the open market, more shareholders enter the picture, giving each one the right to vote on key company decisions. The original owners and closed circle of investors no longer have absolute control of the company.

  • Disclosure: A private company can hide difficulties it may be having, but a public company must report its problems, exposing any weaknesses to competitors, who can access detailed information about the company's operations by getting copies of the required financial reports. In addition, the net worth of a public company's owners is widely known because they must disclose their stock holdings as part of these reports.

  • Cash control: In a private company, owners can decide their own salary and benefits, as well as the salary and benefits of any family member or friend involved in running the business. In a public company, the board of directors must approve and report any major cash withdrawals, whether for salary or loans, to shareholders.

  • Lack of liquidity: When a company goes public, a flow of buyers for the stock isn't guaranteed. For a stock to be liquid, a shareholder must be able to convert stock into cash. Small companies that don't have wide distribution of their stock can be hard to sell. The market price may even be lower than the actual value of the firm's assets because of a lack of competition.

    When not enough competition exists, shareholders have a hard time selling the stock and converting it to cash, making the investment nonliquid.

A failed IPO or a failure to live up to shareholders’ expectations can change what may have been a good business for the founders into a bankrupt entity. Although founders may be willing to ride out the losses for a while, shareholders rarely are.

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