Eli5: How does a private owned company benefit itself financially by going public?
In: Economics
Say you start a lemonade stand. You borrow and spend $100 on a sign, a pitcher, some ice, sugar, lemons. End of the day you’ve sold $100 worth of lemonade. You haven’t made any money yet, but you’ve broke even and paid off the loan.
Let’s say you want to do it again, but you’re flat broke. You now have the signs, the pitcher, and customers, so you know you can sell $100 again- but you need to buy sugar and ice and water.
You offer a friend half the profits if they give you $50. They do and you sell $100 dollars of lemonade again. Good news! You’ve got a solvent business! You can pay your friend their $50 and you still have $50 to spend tomorrow.
Instead of paying your friend back immediately, they say “keep it! You can sell more lemonade tomorrow and just give me half of whatever the lemonade stand is worth at some point.”
So now you’ve sold 50% of your company to your friend. They have 50% equity. This might be called an angel round.
Somewhere along the way you want to build another lemonade stand. You need to take on some more investment, so you check with your friend about inviting someone else into the investment. They are buying in for more than $50 but they are getting a more valuable thing- a third of a very profitable lemonade stand, instead of half of a brand new one.
So that person puts in $200 for a third of the company. This might be called the Series A.
Notice: now you only own a third of your lemonade stand. Your first investor ALSO only owns a third where they used to own half, and the third person paid the most and only ever got a third. This is how “dilution” works. You have put no money in but done a lot of work. Your angel investor gets diluted but still only spent $50 for their third. The series A investor spent $200 on a third.
At this point, the company is worth $600. Your angel investor spent $50 and quadrupled his money. He wants out, but you don’t have the cash to pay him for it because your company just built a new lemonade stand.
So you three agree that instead of thirds, the company is made up of 4,000 shares. Each of you own 1,000 of them- and you’re all three allowed to sell those shares without the others input, to whoever you wish, for whatever price the two parties agree on. The company *itself* owns the extra thousand.
So you hang up a sign on the stands: “buy a share of the company! 20 cents a share!” So a customer could buy a share of the company and it would go to the company, to use for growth and building other lemonade stands. All the owners can sell shares to whoever they like, to get their money back. Angel investors sells all 1,000 shares for $200 and makes a handsome profit!
You sell 100 shares because you need some living money.
The company sells 500 shares and has $100 dollars to use on the stand without borrowing money or diluting shares further.
And once those shares are on the open market, there’s only so many. If someone wants one, they have to buy from whoever has them, at whatever price they can get.
This is the stock market.
So going public is a way of auctioning off fractions of ownership of a company in the open market to allow investors to recoup their investment and the company itself to find capital for growth.
Going public allows you to sell your business — without having to sell your business.
You start a business, it’s going great, everyone loves your product or service, and you decide to go public. You create an estimate of how much your business is worth, which (for this example) is a million dollars.
You issue a million shares of stock, and sell them for a dollar apiece. All of those shares represent the total current value (or market cap) of your business; a million bucks.
BUT you don’t actually sell ALL of the shares. You sell around 20% and keep 80% for yourself. So there are 200,000 available shares for your company floating around in the stock market while you retain 800,000. (To maintain control, the company keeps a minimum of 51%, but some retain a lot more)
Now, you’ve basically sold off 20% of your company, but you didn’t actually sell anything, did you? You get to keep your job, and keep control, and basically nothing has changed except that you have $800,000 worth of stock in your back pocket for whenever you feel like converting it into cash.
Investors and banks are buying and selling shares of your company on the stock market, and slowly but surely, the price starts creeping up. Now the shares of stock that you got for free, aren’t worth $1 anymore, they’re worth $3!!!
So you used to have $800,000 worth of stock, but now you have $2.4 million. You look over at a competing business and offer to buy their company. They say they want $600,000 and you offer 300,000 in cash, and 100,000 in $3 shares of stock. Now you just reduced the number of competitors you had for almost nothing.
When a company performs well their stock price goes up, and the pile of stock they created out of thin air grows more and more valuable, allowing them to be used in place of cash for all kinds of business deals, loan collateral, executive bonuses and so on.
You get the best of both worlds, you get to cash in on the value of your business, have the prestige of being traded on the stock market, with very little downside (unless the stock tanks).
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