Spring 2022 Final Exam Answers for Reasons for Going Public- Finance, University of Houston

Here are some questions asked on the final finance paper at the University of Houston in the Spring of 2022. We have included some answers to help guide you on how to do tests on reasons why companies go public. The blog below will educate you on how to take your finance exams well. We are also an exam writing service, and you can always contact us to do your exams on reasons for going public.

Explain the main factors associated with companies going public and advantages and disadvantages of each factor.

Exam Solution: The table below shows the different factors, advantages and disadvantages

Factor 1 : OUTSIDE INVESTORS PARTICIPATE SUBSTANTIALLY FOR THE FIRST TIME

Advantages

1. From the company's point of view increasing equity capital

If the flotation involves an issue of new shares, the funds raised are received by the company. It may be desirable for the company to increase its equity base to underpin business expansion plans, to introduce new products or to reduce borrowings Forecast requirements for capital may exceed amounts that the original shareholders can contribute, placing limits on the company's development if further sources of capital are not tapped.

The initial flotation paves the way for fund raising exercises in future. This applies not only to the equity markets but to other capital markets. The company's public status in itself is likely to be an advantage. The increased level of information available makes credit analysis and assessment easier and more reliable.

2. For the original shareholders-realizing profits, securing tax advantages, diversifying and raising money.

Existing shareholders may have been financing the company for a prolonged period of time, often without a commercial rate of return on their funds. They may have been working without an arm's length salary to compensate them for their time. Going public provides a convenient opportunity for the original shareholders to take their profits.

It may be more tax efficient for the original shareholders to realize a capital gain on their investment rather than to receive large dividends or salaries. Public company status may also offer tax advantages in countries where tax legislation includes a concept of a 'closely held company. Shareholders may wish to avoid having all their eggs in one basket' and sell shares in order to diversify their investments. There may be a need to raise funds to assist in provision for death duties or other personal matters. Going public provides controlling shareholders with the opportunity to have their cake and eat it. i.e. to sell part of their interests while still retaining control of the company.

Disadvantages

1. Time and expense required

The amount of time required to be devoted by top management to a flotation is very extensive and consistently under-estimated Management finds itself distracted from the day-to-day running of the company at the very time when they would like it to be performing at its best.

The main expenses incurred in going public are discussed below. They can be divided into underwriting and professional fees and other charges such as capital and transfer duties. Some professional fees are likely to be incurred before it is certain that a flotation can proceed.

2. Duties of directors become more onerous and the interests of public shareholders have to be considered

Once a company ceases to be private and becomes public, the responsibilities of controlling and managing it broaden and become more onerous Instead of being answerable only to a small group, usually relatives or close associates, the directors must recognize a duty of trust to a body of public shareholders who will not necessarily be aware of or sympathize with the aspirations of the original shareholders The precise duties of directors vary from country to country but two problems which can cause particular difficulty are:

The directors may well have been accustomed to deal with the company's liquid resources as if they were available for their personal requirements The discipline of segregating the public company's funds may be irksome The system to safeguard this money may be operated by relatively junior employees previously, accustomed to carrying out the controlling share- holders' wishes without question.

In many private groups, there is a considerable amount of intermingling of funds and assets between companies. If moricy is required for a particular project, the assets of other companies may be pledged to raise it, as is most convenient and efficient. A considerable amount of inter-company and inter-group borrowing and lending may go on without security or formal arrangements about charging interest and repaying principal.

3. Constraints on management's actions increase

Once a company has become public, certain corporate actions may require a meeting of shareholders rather than simply a meeting of directors Transactions which are likely to be subject to a vote of shareholders include the issue of more than a certain number of new shares and the sales or purchases of assets which are significant in relation to the size of the business as a whole.

In private company, even if a shareholders' meeting is required, the proceedings are likely to be similar to a directors' meeting. A general meeting of a public company on the other hand can be a very lively affair. If the matters under consideration are controversial, an intensive question and answer session and considerable press coverage can be expected. Even strong executives have been If a public body of shareholders needs to be consulted, relevant information known to quail at the prospect of a stormy public meeting will have to be provided to them well in advance, usually by means of a printed circular The preparation of such a circular needs senior management time I incomplete or biased information is presented, the results of the meeting may not be valid and the directors will be vulnerable to a charge of misleading their shareholders In some jurisdictions, any transaction or contract of material size with directors or substantial shareholders must be approved at a general meeting by a vote of the independent shareholders. This sometimes gives directors and major shareholders of a former private company their first taste of having to subm their actions to the veto of an outside body of opinion The controlling shareholders and directors may be unable to force the proposals through, since, if they are interested parties in the transaction, they will be unable to vote their shares.

Factor 2: MARKETABILITY

Advantages

1. Shareholders may buy and sell more readily

Over the course of time a controlling group of shareholders (often a family) is likely to develop different interests and attitudes towards a company. Some will remain actively involved in the company and its management whereas others, perhaps through marriage or migration, may become remote from its affairs. Not only are the shares of a private company not traded in an organized way but the articles of association usually contain restrictions on the transfer and registration of shares. They will also include a 'pre-emption provision, to the effect that shareholders wishing to sell must first offer their shares to the other shareholders This procedure is cumbersome and may involve the price being set by a neutral party (perhaps the auditors) based on a formula which reflects the limited marketability of the shares. Once a company goes public, the articles of association will be amended to eliminate such provisions. The ability to sell shares freely provides a more satisfactory route for shareholders who wish to go their separate way.

2. The value of the shares is enhanced

Marketability in itself will tend to increase the value of an investment. Some institutional investors are severely restricted as to their holdings of unlisted shares and may not be able to buy the shares at all before they are listed. All investors will look on the increased liquidity of their holding favorably. In a valuation exercise, the multiple applied to the earnings of a public company would be higher than to those of a similar private company, resulting in a higher valuation.

3. Listed shares are more acceptable to banks as security for loans

Once a share is listed, it becomes more acceptable to banks as security for loans, either on its own or as part of a portfolio. This provides an alternative for shareholders who do not necessarily wish to sell but need to raise money from time to time. Provided the shares are reasonably well traded, banks who engage in this line of business will normally be prepared to advance a percentage (say 50%) of the market price of shares pledged to them.

Listed shares are more acceptable for use in acquisitions.

Sellers of assets or shares in companies are normally not willing to accept unlisted securities as a form of payment. Once a company is listed, it may use its shares as consideration in acquisitions, widening its financing options and allowing it to consider bigger targets.

The information publicly available about the company will be sufficient to sustain a listing for, say, new loan stock or preference shares offered to the target company's shareholders, provided adequate details are given of the rights of the security to be issued. The security would need to have a minimum number of holders to ensure marketability, but this will be achieved if a reasonable proportion of the target company's shareholders accept it or satisfactory underwriting arrangements are made. Acceptance of paper rather than cash may have attractions from the vendors' point of view, both from tax considerations and by allowing them to feel they still retain an interest in the asset or business they are selling.

In the early days of a public company's life, it may be necessary to make arrangements for vendors who receive securities in this way to place them on to third parties. As the securities become more widely held and actively traded, these 'back-up' arrangements become less critical.

Controlling shareholders and management must bear in mind that issuing shares in the context of acquisitions will tend to dilute their own control and bring cohesive groups of shareholders, sometimes of significant size, into the company. The new shareholders may have interests and attitudes which could lead to a clash of wills at some future occasion.

Disadvantages

1. The company and its directors must abide by the listing rules of the relevant stock exchange(s)

By definition, the process of gaining a listing on a stock exchange involves compliance with stock exchange rules. A recognized stock exchange is likely to require signature of an extensive formal undertaking to comply with the regulations of that stock exchange for companies whose shares are listed on it. The rules will include requirements that the company follows certain administrative procedures and provides relevant information promptly, particularly regarding results, dividends and other significant corporate developments.

2. Care will be needed over dealings by insiders Directors and other senior executives must accept that they will normally know more about the company than the general body of shareholders. This will restrict the occasions on which they can buy and sell shares. Restrictions are necessary to prevent them being exposed to criticism and possible legal action for dealing in the shares on the basis of privileged or 'inside information.

Directors of a company often feel that the market does not understand or appreciate properly the particular merits of their company. They may also feel strongly that purchases of the shares are an expression of confidence in the company itself However, if purchases are made, for whatever reason, shortly before the release of price-sensitive information (for example unexpectedly good results), the actions of the directors may be questioned. Less frequently, directors may consider the market is unreasonably optimistic about the company's prospects, while they themselves have misgivings. They may feel an obligation to sell shares to protect the interests, for example, of wives and children for whom they are trustees. The same dangers apply to the sales of shares as to purchases.

3. Spread or gradual loss of control

An anxiety commonly felt by shareholders and directors of a private company is the possible loss of control once the company becomes public. Although this is not usually an immediate threat, a potential danger may have been created small shareholders in the context of a private company have little practical recourse if they are unhappy with the way the company is run. Once their shares become marketable, they may be tempted to sell so that for example an apparently solid family block may fall apart. Sometimes even the possibility of a group of outside shareholders appointing a director who is not familiar to the shareholders seems threatening to counter the disintegration of a controlling block, at least 51% of the shares of the public company may be put into a separate private company and the control of that company vested in certain individuals. If family members want to sell they must then sell shares outside the controlling block in such a way that absolute control is not threatened While for some purposes a 75% voting majority is required, even the most anxious of controlling shareholders normally accept that their control is secure if they can command over 51% of the votes at a general meeting of the company.

As the company grows and the spread of shareholders becomes wider, for practical purposes control of as little as 10 or 20% of the company may be sufficient to constitute control of the whole company. This is particularly true if there are a large number of relatively passive shareholders.

Factor 3: COMPANY BECOMES MORE VISIBLE

Advantages

1. Extensive publicity accompanies the flotation

A flotation is a process which requires the publication of a high degree of information about the company. For a company identified with well-known branded consumer items or luxury products, the publicity may become an end in itself, an effective form of image advertising In the months leading up to the launch, the promoters will prepare the ground by a series of strategically placed press articles and announcements to arouse media interest Coverage of the flotation when it actually occurs brings the company, its management and its products before investors' and the public's minds Although some shareholders and managers dread this part of the transaction, other more flamboyant characters revel in it. Previously unknown businessmen may become national figures for a while at the time of flotation of their company. The attention drawn to the company and its business may increase awareness of its floated company immediately attracts a bidder. As the company will normally still be under the majority control of its original shareholders, any such bid could only be on a friendly basis.

Standing of the company increases and attitudes towards it change.

A public company is generally regarded by its customers, suppliers and creditors as having a higher standing than a private company Employees may take a pride in working for a public company rather than an individual or family-owned business A share incentive scheme may be offered to foster a sense of participation. Shareholders, whether employees or not, can become useful advocates if the company is threatened by actions of government such as unfavorable changes to legislation affecting the company.

Although it is difficult to pin down, there is perhaps a feeling that a company of a certain size and reputation ought to be a public company Some general appreciation exists of the rigours and difficulties of going through a flotation. The fact that a company and its management have passed this test is taken as a seal of approval.

There may be a strong streak of 'me too as competitors see their rivals going public and fear that they may obtain some market or financial edge. A similar attitude can be observed among institutions. Once the ice has been broken by a successful flotation, a series of companies in that sector are often brought to market. Individual investors and institutions begin to feel comfortable with a particular type of company and sector of the market and the band-wagon effect is under way. After considerable research and investigation to learn about an unfamiliar industry, there is a natural tendency to try to capitalize on the base of knowledge gathered.

Disadvantages

1. The level of disclosure is increased

Directors of public companies have to come to terms with a substantially increased level of disclosure of information. In a private company, only limited disclosure to 'outsiders' is necessary. In the context of a public company, the information to be published will cover important financial data including announcements of results and dividends, events which affect the management of the company, such as changes in the directors, and alterations in capital structure and shares in issue, which are relevant to investors trading in the shares. There may also be a sweeping provision to disclose any information which is likely to have a material impact on the price or the level of trading of the shares in the Insistence on disclosure may sometimes be interpreted by management as a market questioning of their good faith. They may consider holdings of shares and themselves and their families as nobody's business but their Disclosure of terms of employment such as salary and benefits may be a potential dealings source of embarrassment compared with the anonymity of a private company.

2. Share price is taken as a barometer of the company's fortunes Once a company is listed, details of the share price movements and trading volume are released daily by the stock exchange Arrangements may be made for the share price to appear in major newspapers. Share price movements reflect rumor and market whim as well as fundamentals Management may experience pressure to promote good performance while feeling that the daily ups and downs of the market are largely irrational Bitter comments may be muttered about the tyranny of the share price will be compared by analysts to others in that sector. This may lead to decisions being taken on a short-term basis. For example, if the sector as a whole has shown strong profit increases, actions a particular company might wish to take for long- term development of its business, but which might prove a short-term drag on profits, may be deferred.

If the company is performing well but the sector as a whole is out of fashion, it may be difficult for the market to accept a rating for the company much above the sector average. With the same results but located in a more glamorous sector, the company might be accorded a significantly higher rating.

Factor 4: CHANGES OF PHILOSOPHY

Advantage: catalyst for company to develop from family-run to professionally-managed business

At some stage in a company's development, a change in management style tends to occur. The paternal attitudes often found in a small company give way to a more systematic and objective approach required to control and manage a larger group. Preparation for becoming a public company affords an opportunity and a catalyst for achieving this transition without the appearance of a direct attack on entrenched interests.

An important part of this process involves directors and top management Prior to a flotation, a company is likely to appoint outside directors, typically one or two non-executives of standing in the political, business or financial community. These individuals bring a new perspective to the way problems are tackled and decisions taken. Perhaps for the first time, executive directors will have to explain and justify their action to independent individuals of comparable age, standing and abilities.

A review of the depth and areas of expertise of management conducted a part of the flotation preparations may identity a need for additional qualified executives such as a specialist finance director A professional middle management structure may be missing or inadequate in a private business To sit in recruiting and retaining suitable executives, a share option scheme may be introduced Extended service contracts may be negotiated for senior executives them a greater degree of security and independence. The more obviously distinct identity of a public company.

Disadvantage: ruffled feathers and higher overheads

There may be resistance to change from those who have seen the company grow from its beginnings and recognize no need to alter a winning formula One of the chief skills required in a flotation may be the art of diplomacy Many of the changes in personnel and systems which may be instituted in the context of the flotation cause higher overheads without bringing any immediate improvement in performance of increase in profits In the short term, there may be a period of confusion while new executives find their role in the company and new procedures become established. Developments along these lines may be vulnerable to attack and fall victim to internal politics unless they carry very senior support and are given time to show their worth.