Top 5 reasons why investors should be wary of companies going public

Companies that trade on the stock exchange have the persona they've hit the big leagues. But there are reasons why companies become publicly traded and they don't all work for naive investors.

Let's look at how the stock market functions so we have context for public vs. private markets. Think of a stock exchange as a shopping mall where all possibilities can be found in one place. It's organized and convenient with the benefit of oversight through securities laws and exchange rules. Associated with the listing is a distribution network known simply as the investment industry where investment dealers work with companies to raise capital through their base of Investment Advisors.

In theory, the primary reason companies go public is to raise capital.

Advantages of going public

Attract talent by offering an added pay incentive through a share purchase plan.

Increase enterprise value through the valuation mark up associated with publicly traded companies. The average multiple in the stock market is approx. fourteen meaning the stock reflects a price that is fourteen times earnings. A company earning say $2/share would trade at $28/share. Higher growth companies can trade at significantly higher multiples. A private company might sell for one to four times earnings.

Exposure through the public market provides companies with visibility and a process for being taken over.

Management of publicly traded companies typically use stock for buying other companies rather than cash. It's their currency for building the business with no impact on company operations.

What to watch for

Going public offers private company investors the liquidity event to cash in. Take the April 2018 I.P.O. (initial public offering) by Spotify (SPOT). Sony, who invested in the company while it was private, was able to sell a significant portion of a large dollar investment into the market. Companies undergoing long term growth can still see their share price increase but others may wilt as initial buying becomes exhausted.

Company founders use the public markets to leverage seed capital as well as financings to increase their personal wealth. Exploration companies (oil, gold, etc.) are notorious for this as naive investors fail to recognize the facade of hype with the reality of the company's capital structure and market cycles.

Valuations for resource companies shifting from exploration to production tends to drop. Ironically, as the company generates revenues and earnings the share price may fall considerably.

Publicly traded companies may have extensive research available providing investors with an information source that private companies wouldn't have. But a sell recommendation is rare as investment dealers are unlikely to receive lucrative investment banking business from a company whose analyst has a negative outlook. Furthermore, analysts are using traditional analysis processes without incorporating the realities of the stock market.

Publicly traded companies may offer a significant amount of stock options to management, consultants and advisors. In larger companies with growth it can work but smaller company capital structures can become overwhelmed from significant overhead.

When the stock market is strong I.P.O.s tend to out perform. But when the market is weak newer companies tend to suffer from the heaviest selling.