Why You Can Trust Public Companies More Than Private

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Just being public, should give you some assurance about a company

There is an intense focus on fraudsters and companies that lied to investors.  We love it, be it Enron, WorldCom, Satyam, Valeant, or SinoForest, everyone loves a good fraud story.  Muddy Waters and Jim Chanos live for it.  However, it is worth considering from time to time, that there are a lot of requirements to go public and that the incidence of fraud is quite limited given the degree and depth of controls for publicly-listed companies.

To most it is surprising, but these requirements are fairly equal across the world.  A frontier market exchange usually has developed market level controls and requirements.  We can confidently say that they are not lax in our opinion.  To that end, we thought it would be useful to walk through what a company needs to do, to go public.

The rationale for going public can vary materially based on industry and geographic location.  In North America, a public listing is often a badge of scale, size, and brand; proof that a business has become successful.  In Europe, it is often the opposite where the discretion and control that can be exerted from being private are often more advantageous than the lens which a public profile necessitates.  In other parts of the world, public equity is often the only way to source capital short of egregiously high-interest rates that are materially higher than the cost of equity.

It is worth considering when you evaluate public companies that there is a degree of work that has been completed in order for a company to go public.  Certainly, there are from time to time, companies that have issues with fraud or a misstatement of business facts but these situations are rare relative to the occurrence of such situations within private businesses.  There is a degree of confidence that can and ought to be applied to public companies and also provide perspective to the risks that may be inherent in private equity investments.   There is also the added comfort of knowing that a public company is subject to regulations that a private company would not be (such as the FSA-UKLA or SEC).

To go public, a company has to have a large group of firms vouch for its operations in several areas.  Specifically, sponsors, bookrunners, lawyers, accountants, and PR firms must perform due diligence and put their respective reputations on the line, for a company to have a successful public offering.  Any red flags from these service providers would cripple an IPO.

It is important, however, to also recognize that listing requirements vary based on what type of listing you seek.  For example, a Toronto Ventures (TMX VX) or LSE AIM listing requires a lot less than a full LSE, TMX, or NASDAQ listing.  Outlined below are the differences in requirements for LSE listings.

Prior to an IPO, a company needs to do significant planning and preparation to improve the chances of a successful IPO.  Highlighted below are some of the main areas of focus.

Management team Pre-IPO, a company will need to begin thinking about the degree of credibility that its management team will have with external shareholders.  There is likely going to be a need for training and potentially hiring within the management team to fulfill the expectations of external shareholders that the company is being managed in a way that is aligned with shareholder interests.
Business plan The business should have a firm plan for its purpose, structure, and growth over the short, medium, and long-term.  Not all of this needs to be disclosed, but enough needs to be disclosed to provide investors with information to make a decision as to whether or not they want to invest in the company, given its focus, direction, and perceived trajectory.
Financial performance A company will often need to shift to a noteworthy accounting firm that has credibility such as one of the ‘Big 4.’  Retroactive audits are not uncommon pre-IPO in order to provide investors with insight on how the company has performed over time.  Investors will also expect some degree of information with respect to a forecast for financial performance over the next quarter, year, and 5-years.
Use of proceeds The company needs to provide a detailed plan on how capital raised from the equity would be used in the company.  Investors would be looking for prudent deployment of capital that is well-suited to the company’s growth and business plan.
Financial controls Prior to an IPO, companies need to institute public-level financial controls.  This is often the time when a new auditor/accountant is brought in and controls are tightened and disseminated across the company.  This is usually where new companies are the weakest and is one of the biggest risks that an investor faces.
Board There are a variety of standards that a board is expected to meet and they can vary around the world.  It is expected that a significant portion of the board is independent prior to IPO and that there is a significant amount of diversity on the board.  Diversity from both an experience and expertise perspective as well as from a racial and gender perspective.
Compensation Management compensation and incentives need to be aligned with external investors and conform to the expectations for the particular business’ industry and location.  Fair, well-designed incentives and compensation are welcomed by investors.
Related-party transactions The company will need to think through all of its related parties and then ensure appropriate policies and procedures for all related-party transactions.  In certain instances, related-party transactions may comprise a significant portion of the business and it is critical that an investor knows and understands these arrangements.
Investor relations The company must plan for how it will tackle investor relations once it goes public.  Based on the size of the company, this can vary a fair bit.  Anything from a full IR team to the CEO conducting IR him/herself is acceptable if it makes sense for the company.

Once an IPO is ready, there are a number of next steps that need to be made including the creation of a prospectus, the selection of bookrunners, providing due diligence docs (cap structure, debt covenants, financials, etc.), and the legal structure for completing an IPO.

After IPO, the company must regularly file reports on all insider transactions, as well as provide going concerns guarantees, maintain a minimum market cap, provide quarterly or semi-annual earnings, financial statements in addition to several other requirements.  Companies can lose their listing if they fail to fulfill these requirements and do not heed to warnings.  Admittedly, exchanges are extremely reticent to do this, but they are forced to in certain instances.

Our intent with this piece is not to suggest that you have nothing to worry about with a public company.  It is, however, a way to reassure investors that generally speaking, you can trust the numbers that come from public companies.  You should still always ask questions, verify information and be suspicious but you should not assume that the base case is some degree of manipulation of financials and facts.

As always, any questions, please let us know.  If you would like an in-depth read on this topic, check out the links below.

Further Reading:

A Guide to Listing on the London Stock Exchange

A Guide to Listing on the TSX

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