Multiplying Your Wealth Through an IPO

When a privately held company goes public, it is invariably worth more. Specifically, how does this “alchemy” work? Isn’t it like turning lead into gold? Yes, but once the process is dissected, it’s far easier to understand.

One must understand how market value is set for a closely held, private company to appreciate why a publicly held company is worth more. There are several dynamics to consider.

In most cases the pricing (sales value) of a privately held company is rather simple. The potential buyer usually takes the net earnings of a company and multiplies it by a factor that is standard for the industry. In stock-market parlance, this multiple is called the price/earnings (P/E) ratio.

It is arrived at by taking the market price of a stock (its sales value) and dividing it by annual earnings. My book, You Can Buy a Business, explains this computation in greater detail.

Pricing a Privately Held Company

Let’s put some numbers to this analysis. Assume that your company is earning US$500,000 per year. Note that there are different definitions of earnings, which, for brevity and simplicity, I won’t discuss here. Take the net earnings of your company and multiply it by a factor that is common for your industry — the P/E ratio.

For example, let’s say that the P/E ratio is 5. Your business would be worth US$500,000 X 5, or $2.5 million. Later in this column, I compare this $2.5 million valuation to a publicly held valuation for the same company.

A note of caution to potential purchasers: Not only must you determine that the multiple, in this case 5, is fair, you must also do your homework and make sure that the company is truly earning $500,000 per year.

Examining and vetting a company to prove the accuracy of its accounting data is called “due diligence.” It is a critical process in the valuation of a company. In a future column, I will be discussing this process in great detail.

Pricing a Publicly Held Company

Here’s where the process changes quite a bit. The formula is basically the same: The company is priced at a multiple of earnings. The dynamic factors that go into that multiple, however, are a bit involved. What are these factors?

Let’s examine what influences the buyer of a publicly held company as compared to a buyer of a privately held company. First, there is risk.

The buyer of a private company takes more of a risk than his or her public counterpart. Why is this? Usually, the buyer has to come up with a chunk of cash to make the deal. Alternatively, the buyer might be able to finance part of the purchase price. But that, too, involves a good deal of risk in that usually he or she will be liable personally for the debt incurred to make the purchase.

So, the risk factor is substantially higher than that for the purchaser of public stock in that a purchaser of public stock is usually buying only a small portion of the company’s outstanding stock and normally does so with his or her own cash, without having to borrow money for the acquisition.

Time, Energy and Liquidity

Another major influencing factor to consider is the time and energy involved. A buyer of public stock can sit back and occasionally read stock reports on the company or watch the daily stock quotes.

A purchaser of a private company usually has to be intimately involved in the day-to-day operations of the company. This normally requires a major commitment of time and energy.

Thus, there is a smaller universe of buyers for a private company than for a public company. This factor alone tends to depress the P/E multiples of private companies.

Think about the involved process that the buyer has to go through to purchase a privately held company. This process tends to limit the number of possible buyers. Well, if the buyer decides to sell, potential buyers will have the same difficulty that he or she had buying the company in the first place.

In other words, the stock of a privately held company just isn’t as liquid as that of a public company. When you want to sell stock in a public company, it’s usually merely a case of calling your broker and placing a sell order. It’s not so easy to sell a private company.

Legal Exposure and the Numbers

When you buy stock in a public company, the most you can lose is your investment. That’s bad enough. But when you purchase a private company, there is always the chance that some disgruntled customer or supplier might decide to sue you personally.

Yes, usually incorporating a private company protects you from many possible lawsuits, but not all. This is another factor that tends to depress the price/earnings multiple of a private company as opposed to a public company.

Because of the pricing differentials created by the above dynamics, publicly held companies are usually worth substantially more than their private counterparts. Let’s take our example of a company earning $500,000 and value it as both a private company and a public company.

Hypothetical Pricing

Let’s assume that the P/E ratio for the public company happens to be 15:

For the private company, the earnings of $500,000 would be multiplied by the P/E ratio of 5, as determined above, for a value of $2.5 million. For the public company, those earning would be multiplied by the P/E ratio of 15, making for a value of $7.5 million.

It’s quite obvious that the greater value lies with the publicly held company. The dynamics that I noted above demonstrate why investors are more likely to pay a higher P/E ratio for public companies as opposed to private ones.

Does this mean that you should take your private company public? Not necessarily. Take a look at my previous articles on this subject: “Finding Dollars for Small-Cap Companies” and “Is Going Public the Right Move for Your Company?“

The latter article goes into great detail about the things you should consider before going public with your company. The former article shows how a small company can do an IPO and raise money even in the current environment that favors the large, underwritten IPO.

When you’ve reached the point that you are considering taking your company public, you should analyze as many relevant factors as possible to ensure the accuracy of your decision. Good accounting and legal advice from professionals who have experience in IPOs is a must. But the final decision has to come from you. Good luck!