Sunday, July 24, 2011

Stay Private vs Going Public: Changing landscape

For much of the last century, as public equity markets have grown, the choice for owners of private businesses that had growth potential was a simple one. Stay private, with limited access to equity capital or go public? In making the decision, the owner weighed the pluses and minuses of a public offering. On the plus side, liquidity increases and you have access to far more capital, generally at a lower cost, since the investors buying your equity tend to be more diversified (and thus willing to overlook a portion of the risk in your company). On the minus side, you risk loss of control (if not right away, but at some point in time in the future; remember the cautionary tale of Steve Jobs and Steve Wozniak being forced out of Apple in the 1980s) and you also have far more stringent corporate governance rules (think Sarbanes-Oxley) and information disclosure requirements. The venture capital market eased the transition, by allowing small firms that were not ready to go public to raise equity from private investors, albeit at a higher cost than they would pay in public markets.

To capture how the diversification status of the potential equity investor affects the cost of equity, I developed a scaled measure of beta a couple of decades ago, with the beta changing as a function of the diversification status:

Thus, a company with a market beta of 0.8 (to a diversified investor) can have a total beta of 2.4 (to a completely undiversified owner) and 1.6 (to a partially diversified venture capitalist). I have a data set that summarizes my estimates of market and total betas by sector for US companies that you can take a look at, if you are interested.

In the last few years, there have been two developments that have muddied the waters and changed the dynamics of whether and when firms go public. The first is the development of a private share market, where shares of private business can be traded by their owners, granting private businesses many of the advantages that they would have as public companies without much of the information disclosure/monitoring requirements that come with being public. Facebook is perhaps the most prominent example of a private business that has access to as much capital as almost any public company through this market. The second is the insidious route adopted by some non-US (primarily Chinese) private businesses that have bought small publicly traded US companies and used these companies as shell vehicles to gain access to public equity.

In both cases, equity owners of these businesses are badly served, since they own portions of private businesses without the right to access information or influence management (that they at least in theory have with public companies). In know that the obvious fix to both these problems is to regulate these options, either by extending public company scrutiny to firms in the private share market or by barring trading in the market. However, the people who buy equity in Facebook in the private share market or a Chinese shell company are doing so voluntarily. Presumably, they are pricing in their concerns (or lack thereof) into what they pay and deserve to get whatever upside (or downside) they get from their investments. I will not envy them their returns but I will certainly not shed any tears for their losses, either. So, Facebook equity investors, I hope you make money on your investments.. but with Mark Zuckerberg as your lead partner, you should perhaps consult the Winkelvoss twins on how well your interests will be served.


John said...

Although I doubt it will be repeated regularly, a 180% (35 -> 83) premium for liquidity and transparency seems like a good deal for LNKD investors.

Brendan said...

Isn't there already some degree of regulation of private share markets with the 500 shareholder rule and the requirement to be a qualified investor?

Another interesting development with these private markets is the valuations that get attached to private companies (with no public financial data) that eventually set expectations for management to deal with. This happens in public market as well, but in theory it is more rational (there are filings to use as a starting point).

Aswath Damodaran said...

Brendan. You are right, though attempts are being made to ease the 500 shareholder rule.

Lankan Markets said...

Dear Professor,

In your post you mention one plus side as 'more capital at lower cost'. I'm concerned if equity is low cost? Coz in our basic finance course we learn that equity is the highest cost component. Appreciate if you could clarify.

Thanks you.

Aswath Damodaran said...

The cost of equity to a public company is lower than the cost of equity to an otherwise similar private company. The cost of equity for both will be higher than the cost of debt.

Lankan Markets said...

Dear Professor,

Thank you for the clarification. If you have any research paper on this topic I'd appreciate a copy.

Thanks once again.


The Doors Of Perception said...

So here's a thought experiment: i form a company with 1B shares, and i sell 1 share to you at $1. now my company has a $1B valuation :D

now, isnt this what Facebook and other internet startups are raising money on?

as you propose, shouldnt percentage of float be a factor in valuation?