Reading Financial Reports For Dummies. Lita Epstein
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In private companies, family members can easily decide how much to pay one another, whether to allow private loans to one another, and whether to award lucrative fringe benefits or other financial incentives, all without having to worry about shareholder scrutiny. Public companies must answer to their shareholders for any bonuses or other incentives they give to top executives. Private-company owners can take out whatever money they want without worrying about the best interests of outside investors, such as shareholders. Any disagreements the owners have about how they disburse their assets remain behind closed doors.
Greater financial freedom: Private companies can carefully select how to raise money for the business and with whom to make financial arrangements. After public companies offer their stock in the public markets, they have no control over who buys their shares and becomes a future owner. If a private company receives funding from experienced investors, it doesn't face the same scrutiny that a public company does. Publicly disclosed financial statements are required only when stock is sold to the general public, not when shares are traded privately among a small group of investors.
Defining disadvantages
The biggest disadvantage a private company faces is its limited ability to raise large sums of cash. Because a private company doesn't sell stock or offer bonds to the general public, it spends a lot more time than a public company does finding investors or creditors who are willing to risk their funds. And many investors don't want to invest in a company that's controlled by a small group of people and that lacks the oversight of public scrutiny.
If a private company needs cash, it must perform one or more of the following tasks:
Arrange for a loan with a financial institution
Sell additional shares of stock to existing owners
Ask for help from an angel, a private investor willing to help a small business get started with some upfront cash
Get funds from a venture capitalist, someone who invests in start-up businesses, providing the necessary cash in exchange for some portion of ownership
These options for raising money may present a problem for a private company because
A company's borrowing capability is limited and based on how much capital the owners have invested in the company. A financial institution requires that a certain portion of the capital needed to operate the business — sometimes as much as 50 percent — come from the owners. Just as when you want to borrow money to buy a home, the bank requires you to put up some cash before it loans you the rest. The same is true for companies that want a business loan. I talk more about this topic and how to calculate debt-to-equity ratios in Chapter 12.
Persuading outside investors to put up a significant amount of cash if the owners want to maintain control of the business is no easy feat. Often major outside investors seek a greater role in company operations by acquiring a significant share of the ownership and asking for several seats on the board of directors.
Finding the right investment partner can be difficult. When private-company owners seek outside investors, they must ensure that the potential investors have the same vision and goals for the business that they do.
Figuring out reporting
Reporting requirements for a private company vary based on its agreements with stakeholders. Outside investors in a private company usually establish reporting requirements as part of the agreement to invest funds in the business. A private company circulates its reports among its closed group of stakeholders — executives, managers, creditors, and investors — and doesn't have to share them with the public.
A private company must file financial reports with the SEC when it has more than 500 common shareholders and $10 million in assets, as set by the Securities and Exchange Act of 1934. Congress passed this act so that private companies that reach the size of public companies and acquire a certain mass of outside ownership have the same reporting obligations as public companies. (See the nearby sidebar “Private or Publix?” for an example of this type of company.)
Publix Super Markets is a private company owned by more than 101,000 shareholders. You can think of it as a semipublic company. However, until Publix actually decides to sell stock on a public exchange — if it ever does — it's classified as a private company. Publix makes its stock available during designated public offerings that are open only to its employees and nonemployee members of its board of directors. It also offers employees a stock ownership plan, which has more than 140,000 participants. So even though Publix stock isn't sold on a stock exchange, Publix must file public financial reports with the SEC.
In some cases, private companies buy back stock from their current shareholders to keep the number of individuals who own stock under the 500 limit. But generally, when a company deals with the financial expenses of publicly reporting its earnings and can no longer keep its veil of secrecy, the pressure builds to go public and gain greater access to the funds needed to grow even larger.
Understanding Public Companies
A company that offers shares of stock on the open market is a public company. Public company owners don't make decisions based solely on their preferences — they must always consider the opinions of the business's outside investors.
Before a company goes public, it must meet certain criteria. Generally, investment bankers (who are actually responsible for selling the stock) require that a private company generate at least $10 million to $20 million in annual sales, with profits of about $1 million. (Exceptions to this rule exist, however, and some smaller companies do go public.)
Before going public, company owners must ask themselves the following questions:
Can my firm maintain a high growth rate to attract investors?
Does enough public awareness of my company and its products or services exist to make a successful public offering?
Is my business operating in a hot industry that will help attract investors?
Can my company perform as well as, and preferably better than, its competition?
Can my firm afford the ongoing cost of financial auditing requirements (which can be as high as $2 million a year for a small company)?
If company owners are confident in their answers to these questions, they may want to take their business public. But they need to keep in mind the advantages and disadvantages of going public, which is a long, expensive process that takes months and sometimes even years.