There comes a stage in every company’s lifecycle when going public makes sense. It might be to maintain growth, pull off more aggressive expansion, or bring on new shareholders to gain access to resources and knowledge. Before doing so, a startup (or private company) should give some thought to the differences between a private and public company, especially in terms of what analysts and investors take into consideration when valuating.
The term “private company” covers an array of businesses; all the way from single-employee (non-incorporated) to startups, to former public companies who became private after a buyout. This is how diverse the characteristics are that make a company “private,” and with this diversity of characteristics are equally diverse factors that analysts look at when valuating. Let’s look at five.
For all intents and purposes, a private company in this article is simply one that is not listed on a public stock exchange, such as the JSE.
Size… the cost of being public
Size might seem the most obvious meter of valuation, and it potentially is. Size includes factors such as staff, income, balance sheets et al. From an analyst’s perspective size has implications for the level of risk an investor might take on. The general rule is small size equals more risk. This means that risk levels and premiums are higher for smaller companies, which analysts and investors take into account when estimating their ROI. A small size can reduce growth prospects because there is less access to capital to fund expansion.
However, on the other side of the valuation coin is the higher costs of running a public company. This is not just because of larger operations, staff etc. but also because the compliance costs to be publicly listed on a stock exchange is quite high. So an investor will always look at whether the financial benefits of being listed on a stock exchange outweigh the costs of operating as a public company.
Overlap of shareholders and management
For most private companies, the shareholders are generally involved in the management of the company. In many startups for example, the shareholders are often the founders. This aligns shareholder and management goals. A public company does not enjoy this luxury, and pressure from, and reporting to, external investors (the shareholders) can slow down the pace at which decisions get made. Analysts take this alignment, or lack thereof, into account when valuating companies.
Shorter and longer-term investment strategies
This ties into stock price performance. A publicly listed company is under pressure to have consistent growth rates and earnings as it directly relates to its stock price performance. The smallest change can affect this performance. For example, if a high-profile management employee leaves a company, its stock might go down. It’s all about perception.
Some investors also have a short-term trading strategy. This is particularly true ever since the financial crisis struck in 2008. Short-term traders often look at the month to month, or quarterly to quarterly performance and expect results in that time period. This results in the management of a public company trying to meet short-term goals rather than looking towards the future.
Private companies are mostly invested into with the longer-term in mind. VCs for example, often enter with a three to five-year plan before exiting. This means management can work towards that five-year plan, theoretically with more reward, and less immediate pressure. This is not necessarily a pro or con one way or the other, but it’s definitely something to bear in mind before taking your company public.
Quality and depth of management
A small private company like a startup, is theoretically less attractive to high-quality management candidates because it can’t match the salary or benefits of a larger business. This means that startups generally have less management depth than a public company which increases the risk in valuation, as growth prospects are lower than they would be for a public company with strong, experienced management candidates.
Quality of financial information and reporting requirements
One of the less glamorous differences between a private and public company is the quality of financial information accessible to (potential) investors. In short, private companies have lower quality – and most likely less detailed – financial information than public companies. This increases the risk, and the higher the risk, the lower the valuation.
Public companies though, have to meet requirements for submitting financial reports which they often produce quarterly. These reports have to be of a high quality, and contain sufficient detail, to please external shareholders.
The lesson here is for startups to not overlook the importance of keeping their books correctly, and also in being transparent when it comes to receiving investment. Think of it this way, make the potential investor’s job as easy as possible to get the information they need to make an educated investment decision.