The Benefits of Being a Public Company and Trading for Emerging Growth Companies

July 22, 2013

By David N. Baker

Merchant Liquidity Fund, LP

Mercadyne Investments, LLC

 

After considering the multiplicity of methods and structures to fund, grow, promote, validate, value and monetize a business, we have found none superior to becoming a publicly traded company.  Accordingly, we are vigilant advocates of the compelling value proposition that supports private emerging growth companies aspiring to be publicly traded; as it is the optimal path for capital formation during the formative years and has historically, with few exceptions, created the most successful, dominant and enduring enterprises.  Being publicly traded provides companies with several important quantitative and qualitative benefits that cannot be enjoyed by companies remaining private.

 

Visibility

Being publicly traded and possessing a stock symbol connected to the company name and making business and financial disclosures publicly available to all whom are interested, provides a company with a level of visibility that is geometrically greater than and potentially cannot be achieved by, a private company.  The media is much more likely to pay attention to a company that is publicly traded due its visibility.  Customers, strategic partners, employees and investors, prospective and current, have a much stronger nexus to the company and its brand(s) and are usually more responsive, more comfortable and more likely to invest and re-invest in a public company, than one that is private.

 

Capital–Investor TAM

Access to capital is perhaps the most obvious and in reality the most popular reason companies go public.  Being a public company attracts the largest total available market (TAM) of investors.  For the U.S. capital markets, including exchanges and electronic market places (e.g. NYSE, NASDAQ, OTC Markets (OTCQX, OTCQB), etc.), such audience of prospective investors is global.  In contrast, private companies have the smallest total available market of investors (which historically has been localized within a short geographic radius to company location); generally venture capital and angel investors and now crowd sourced funding.  Even with the passage of the JOBS Act, there are financing limitations imposed upon crowd funding for both the companies and individual investors; and private equity is rarely if ever interested in investing in emerging growth companies, in favor of much larger, predictable and stable companies [an exception is our own Merchant Liquidity Fund LP].  Due mainly to issues of trust, emanating from the transparency that is provided from public disclosures, as well as liquidity and even brand awareness as a function of the public nexus that is created, investors are much more comfortable investing in a publicly-traded company than one that is private.

 

Financing Access And Company Growth

Publicly traded companies are able to access the capital markets with greater frequency, seek larger amounts of capital with less dilution and close their financing transactions much faster than private companies.  This allows them to take advantage of a greater number of business opportunities and therefore maximize their growth. The financing access advantages for public companies catalyze their growth to such an extent that they are able to “shave time” and gain years of time-to-market advantage over most private companies.

 

Copyright 2013 Mercadyne Investments LLC  All Rights Reserved.

In contrast, private companies are not able to access capital with similar frequency.  For example, private companies seeking a subsequent financing to their initial round (post Series A), generally must have completed a milestone(s) that its investors (venture, angel, crowd sourced, etc.) deem a “financeable event,” whether it be operating results, a product achievement or scientific (high tech or biomedical) end point, in order to complete a subsequent round of financing that includes existing (“follow on”) investor support.  Otherwise the company is often left “stranded” to complete a financing on its own and seeking new investors to identify and close (of course with no liquidity to offer its new or previous investors).  Again, there are exceptions.  In the last 15 years, companies such as Google, Facebook and Tesla financed privately with their IPO’s being their “final” financing event; but such companies are 1 in 10,000 and therefore statistical anomalies.

 

Public companies are able to finance solely for prospective reasons, whether they are already successful, or even if they have historically experienced significant challenges; in which case the financing will be a function of price and terms.  Public companies tend to have “9 lives,” when it comes to financing capability and frequency.  Private companies often fail, independent of underlying fundamental merit, when experiencing challenges.

 

Independent of the fact that investment terms (e.g. covenants, control provisions, preferences) are usually inferior (if not onerous) for private companies, they are also receiving lower valuations than their public company comparables; and are therefore highly concerned with dilution (as perhaps they should be).  Due to this concern, the capital amounts they raise are usually insufficient to optimize their growth.  Moreover, the duration to close private company transactions is normally several weeks and sometimes months.  For pubic companies, depending upon whether it is a registered or unregistered transaction and other factors, it can be only days.

 

Liquidity

Public trading provides shareholders with liquidity which positively impacts shareholders in providing them maximum flexibility regarding considerations of control, succession planning, partial monetization of their holdings, transferability, increasing the value of their stake holdings as a multi-year investment hold and ultimately upon complete exit.  Public liquidity enables shareholders the ability to monetize their shares without ceding control of the company.  Similarly, family owned or majority owned businesses or those companies with concentrated control ownership compositions can avail themselves of succession planning by virtue of public liquidity; and at the same time providing their minority shareholders the opportunity to monetize all or a portion of their holdings at a time of their own choosing.  Share liquidity provides all shareholders with transferability, which in turn facilitates the ability to margin or collateralize for further financial activities and additional capital formation.  Liquidity provides investors with a choice and a realizable value for their shares.

 

Valuation and Terminal Value

Public trading creates the best (read–highest) and most sustainable valuation for shareholders (individual, institutional, corporate and sovereign), other than a complete

sale of the company.  By making shares publicly traded, in a continuous market

accessible through any broker, electronic, direct or full service, companies create a huge wealth effect for their stakeholders, as their investors have a readily transferable asset that can be deposited in brokerage and trust accounts. It is much easier to value a company when it is publicly traded, with widely disseminated, easily accessible, dynamic quote and trade data, and publicly disclosed financial information, as well as news and product and service-related releases supporting the financial information and stock price.  A public valuation also gives a company an accurate portrayal of its overall worth, and provides real-time, dynamic, “marked-to-market,” feedback as the market reacts to company news and disclosures (qualitative and quantitative). Public valuation gives investors confidence in the value of the shares they hold, allowing them to accurately assess their finances for this asset class and enabling them to trade their shares with confidence from the daily, real time and marked-to-market value.

 

Copyright 2013 Mercadyne Investments LLC  All Rights Reserved.

When seeking terminal value (defined as the [maximum] value of an asset or company at a future

valuation date) in connection with a sale of the company, two standard valuation methodologies are often applied:  the exit model which utilizes enterprise value and related derivative calculations; and/or the perpetuity growth model which identifies free cash flow.  Barring a “take under,” which is extremely rare, the public company target receives a premium above its stock price, often substantial, which takes into account a future value for the company many years in the future, far in excess of standard (defined as mean and average) multiples of financial ratios and operating metrics.  Meaning that public companies often enjoy “true” maximum terminal value whereby the suitor is paying the public company target a “conjunctive valuation” (“two premiums”), by applying both the exit model and the perpetuity model or hybrid thereof, to calculate the consideration being offered for their tender.

 

While private companies often do receive a substantial premium to their current valuation in connection with a sale of the company, it is often much less than it would be if it were a public company.  This is the case because the private company target usually receives a “disjunctive valuation” (single premium) from the suitor of either the exit model or the perpetuity growth model, depending upon the stage of the company; not both.

 

In the case of a public company target, the suitor must usually apply bother terminal value models in calculating its offer, because it is obligated to pay a premium sufficiently above the target company’s stock price, in order to gain shareholder approval by the target.  Current market capitalization and corresponding lofty multiples of financial ratios and operating metrics are irrelevant if it wants or needs a successful acquisition of the target company.

 

Dilution

Due to higher valuations afforded publicly trading companies as compared to private companies, companies that are publicly trading experience less dilution from financings than private companies.  Because almost all emerging growth companies conduct multiple rounds of financing during their formative years, companies that access the public capital markets early in their life cycle have the distinct advantage of capturing a valuation increase due to two main reasons.  One is the private-to-public market multiple expansion.  Public companies usually receive significantly higher multiples of financial ratios and operating metrics than private companies, resulting from investors’ positive response to public transparency, disclosure (of operating results, company news and events and products and services) and liquidity.  The second reason is that as a result of the underlying liquidity from being publicly traded, discounts to market price for financings of publicly traded companies that have built a reasonable amount of liquidity in the market for their security, are often 6%-15% and sometimes they are priced with no discount at all.  Additional factors affecting financing discounts include but are not limited to, whether or not the financing is registered, market sentiment and other factors.

 

Private company financings, market sentiment (for asset class and sector) being ceteris paribus, often carry 30%-40% valuation discounts to public company comparables, taking into account the lack of transparency of historical operating results and lack of public company validation (e.g. PCAOB audit) the illiquidity of the investment and the weighted average cost of capital.

 

The positive disparity [expansion] in valuation for publicly trading emerging growth companies translates to enormous savings, via reduced dilution, over the course of even just a few financings.  Over the course of just a few financings this can save current stakeholders 20% to 35% of the entire company’s equity capitalization.  Obviously such equity savings to stakeholders is material and can positively impact companies’ strategic and tactical decision making about all aspects of their business including fundamental opportunities to be taken advantage of from this large savings in equity; not to mention the increased earnings leverage achieved from reduced dilution.  This earnings leverage translates to faster achievement of profitability crossover and once again, higher valuation (market capitalization).

 

Copyright 2013 Mercadyne Investments LLC  All Rights Reserved.

Currency

Publicly traded companies are able use their stock as currency to make acquisitions.  Utilizing this method of purchase, they do not need to affect their balance sheet by using cash, expanding credit or conducting another financing to facilitate the acquisition.  In most instances, private companies have no way of making wanted or needed acquisitions.  They don’t have the cash and because they are private there is little or no liquidity and no verifiable, durable value for their company and corresponding security.  In any event, most target companies will not accept “private paper” as consideration for a purchase and instead require cash or shares of a publicly traded company.

 

Trust

Publicly traded companies build trust from the capital markets, industry, community and society, faster and more easily than private companies.  Their reputations are built from all facets of transparency that accompanies the elements of being a public company.  These facets of transparency in turn create the strongest nexus between the Company and its investors, employees, customers, strategic partners and the media (“company-related participants”).  Generally, the greater the nexus, the stronger the company becomes in all respects.  This nexus then generates greater success for the company and its stakeholders, as well as all company-related participants.  The result is that transparency and reputation builds trust and public companies become more durable, sustainable and successful from this trust.

 

David N. Baker is the Managing Member of Mercadyne Investments LLC and the Managing Partner of Merchant Liquidity Fund LP.  Merchant Liquidity Fund makes negotiated private equity investments in the securities of privately held emerging growth companies that are planning to, capable of and contractually committed to, becoming public within a reasonably short timeframe (generally less than 9 months) via Alternative, Direct and Initial Public Offerings.  Mr. Baker has extensive experience in financing start-up companies and managing capital for institutional and accredited investors.  Mr. Baker has raised in excess

of $200 million solely for early stage micro-capitalization companies.  Mr. Baker has led as investment

principal, originating, structuring and investing in reverse merger, self-registration and other alternative going public (APO) and direct public offering (DPO) transactions for numerous emerging growth companies, as

well as advising them in all stages of their corporate lifecycle, from startup through IPO, APO, DPO and subsequent public registered and unregistered financings.  These companies cover a broad range of industry sectors including:  consumer products, gaming, broadcast media, e-commerce, information technology, renewable and clean energy (distributed wind turbine and solar), mobile content and hardware, automotive, biotechnology and natural resource sectors.  In addition, his career has included positions as the managing principal of two hedge funds, other investment management capacities, technology and healthcare merchant banking, proprietary trading and securities brokerage.  Mr. Baker was the Co-Founder and Executive Chairman of Xzeres Corp. from February, 2010-December 2012.  Mr. Baker was also the Chairman, CEO and Co-Founder of SectorBase, Inc., a sector specific, securities database for financial institutions, acquired in 2001 by an affiliate of Preferred Trade. He is also the co-inventor of two financial analytics patents, including a design for product/service hierarchy database for market competition and investment analysis, as well as a patent for a granular method for index performance by sector.  Mr. Baker earned a B.A. in 1989 from the University of Colorado and received a J.D. in 1992 from Golden Gate University, with a focus on securities.  Mr. Baker lives in Bellevue, Washington and has a son Leonidas.

 

Mercadyne Investments, LLC | dnb@mercadyne.com | www.mercadyne.com | 206.552.0978 

Copyright 2013 Mercadyne Investments LLC  All Rights Reserved.

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