Chapter 3
Discovering How Company Structure Affects the Books
In This Chapter
Looking at the private side of business
Investigating the public world of corporations
Examining what happens when a company decides to go public
Not every company wants to be under public scrutiny. Although some companies operate in the public arena by selling shares to the general public on the open market, others prefer to keep ownership within a closed circle of friends or investors. When company owners contemplate whether to keep their business private or to take it public, they’re making a decision that can permanently change the company’s direction.
In this chapter, we explain the differences between public and private companies, the advantages and disadvantages of each, and how the decision about whether to go public or stay private impacts on a company’s financial reporting requirements. We also describe the process involved when company owners decide to make their company public.
Many people use the term public company as a shorthand way of saying that the company is listed on the stock exchange. As a result, we also use that shorthand description in this chapter.
Investigating Private Companies
Private companies are not allowed to sell shares to the general public, so they don’t have to worry about the reporting requirements that face the public company. A private company gives owners the freedom to make choices for the company without having to worry about outside investors’ opinions. Of course, to maintain that freedom, the company must be able to raise the funds necessary for the business to grow – through profits, debt funding, or investments from family and friends.
However, private companies do have to place information on the public record at Companies House (refer to Chapter 2). When it comes to reporting financial performance, the extent of information required depends on the size of the company. See the section ‘Figuring out reporting,’ later in this chapter.
Keeping it in the family
You don’t have to go public to go global. The Virgin Group of companies, one of the most recognised brands in Britain, is pretty much a global brand despite being a private company. The Virgin Group has been involved in planes, trains, finance, soft drinks, music, mobile phones, holidays, wines, publishing, space tourism, cosmetics, and probably a lot more by the time you read this. Virgin has more than 200 companies worldwide, employs over 35,000 people, and boasts total revenues measured in many billions of pounds.
Virgin’s strategy, or rather that of its owner Richard Branson, is that the company stands for ‘Value for money, quality, innovation, fun, and a sense of competitive challenge’. Like most entrepreneurial companies, Virgin is very customer-oriented. It does its homework before going into a new enterprise, looking at the industry from the customer’s viewpoint and asking the simple question ‘How can we do this better?’
Virgin is an example of a company that has gone to the public market and found it not to its liking. Virgin Group – comprising its music, retail, property, and communications businesses – was floated on the stock exchange in 1986 (the airline and travel businesses, in contrast, remained privately owned). The stock witnessed limited capital growth after the launch date and, like the equity market as a whole, suffered in the stock market crash of 1987. Richard Branson also expressed disappointment with the short-term expectations of equity analysts and fund managers. This dissatisfaction culminated in the decision in 1988 to make the company private again through a management buy-out at precisely the same price at the launch in 1986.
Checking out the benefits
Private companies maintain absolute control over company operations. With absolute control, owners don’t have to worry about what the public thinks about its operations or the need to satisfy the City’s profit watch. The company’s owners are the only ones who worry about profit levels and whether the company is meeting its goals, which they can do in the privacy of a boardroom.
Further advantages of private ownership include:
Confidentiality: Private companies can limit the amount of information that they must file to the minimum laid down by law. Competitors can take advantage of the information disclosed by public companies. Private companies can leave their competitors guessing and even hide a short-term problem because they do not need to place information on record until several months after the end of the financial year affected.
Flexibility: 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 without having to worry about shareholder scrutiny. Public companies must answer to their shareholders for any bonuses or other incentives given to top executives. In a private company owners can take out whatever money they want without worrying about the best interests of outside stakeholders. Any disagreements the owners have about how they disperse their private company’s assets remain behind closed doors.
Greater financial freedom: Private companies can carefully select how to raise money for the company and whom to make financial arrangements with. After public companies offer their shares in the public markets, they have no control over who buys their shares and becomes a future owner.
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 shares or offer bonds to the general public, it spends a lot more time 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 without some sort of guarantee or control – such as a seat on the board. 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 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, which is 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 may well require that a certain portion of the capital needed to operate the business – sometimes as high as 50 per cent – comes from the owners. Just like when you want to borrow money to buy a home, the bank requires you to put up some cash before it will lend you the rest. The same is true for companies that want a business loan. We 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 company is no mean feat. Often, major outside investors seek a greater role in company operations by acquiring a significant share of the ownership and asking for seats on the board of directors.
Finding the right investment partner can be difficult. When private- company owners seek outside investors, they must be careful that the potential investors have the same vision and goals for the company that the owners do.
Another major disadvantage that a private company faces is that the owners’ net worth is likely to be tied almost completely to the value of the company. If a company fails, the owners may lose everything and may possibly even be left with a huge debt. If owners take their company public, however, they can sell some of their shares and diversify their portfolios, reducing the risk in their personal portfolios.
Figuring out reporting
Reporting requirements for a private company vary based on its size. The reporting requirements for a large private company are very similar to those which apply to an unlisted PLC.
Private companies will soon be required to file a copy of their financial statements at Companies House within nine months of the end of the financial year. (This was ten months until the change brought in by the Companies Act 2006 which will become effective during 2009.) The PLC will have to file the financial statements within six months of the year-end (previously seven months).
The financial statements consist of:
Directors’ Report – which includes a review of the business and a description of how the business uses financial instruments as well as a host of other interesting data such as donations to charities and political parties. In simple terms, the term financial instrument refers to any contract between the company and an outsider which is described in financial (that is, money) terms. Examples range from bank deposits, bank loans, trade receivables, and so on, through leases to more complicated contracts such as interest rate swaps or forward exchange contracts.
Auditor’s Report – which expresses an independent opinion on the truth and fairness of the accounts and is signed by an independent registered auditor.
Profit and Loss Account – formatted in accordance with the Companies Act rather than the International Standards.
Balance Sheet – also formatted in accordance with the Companies Act rather than the International Standards.
Cash-Flow Statement – this is not a Companies Act requirement but was introduced into UK accounting by FRS 1 in the early 1990s.
Notes to the accounts – to pick up the mass of other disclosure requirements laid down in the Companies Act and UK accounting standards.
Note that small companies (as defined by the Companies Act) are exempt from the requirement to prepare a cash-flow statement and can produce a simplified Directors’ Report.
Medium-sized companies
Medium-sized companies are given very few concessions compared with larger private companies. In the past, they would not need to disclose turnover in their filed accounts nor would they need to prepare group accounts. Both of these concessions are in the process of being removed by the Companies Act 2006.
Turnover is not more than £22.8 million.
Gross assets (fixed assets plus current assets) are not more than £11.4 million.
Number of employees is not more than 250.
To qualify as a medium-sized company, the company must usually satisfy the conditions in two consecutive years. Further, a company is ineligible to be medium-sized if it is a PLC or if it is involved in financial services or if it is a member of a group containing an ineligible company.
The financial limits increase at regular intervals and another increase is expected to take effect in 2008.
Small companies
Turnover is not more than £5.6 million.
Gross assets (that is, fixed assets plus current assets) are not more than £2.8 million.
Number of employees is not more than 50.
The limits for turnover and balance sheet increase at regular intervals and another increase is expected to take effect in 2008.
Again, the company must usually satisfy the conditions in two consecutive years and the company is ineligible to be small if it is a PLC or a member of a group containing an ineligible company. The restrictions concerning ineligibility of financial services entities are less restrictive for the small company definition.
Although small companies may file abbreviated accounts, they must still issue full accounts to their shareholders – although these accounts are simplified when compared with medium-sized or larger companies. Small companies are entitled to follow the Financial Reporting Standard for Small Entities (FRSSE) which is a cut-down version of full UK GAAP. All Companies Act requirements are included in the FRSSE as are almost all of the rules regarding the way that items are measured in accounts. Where the small company benefits is that the FRSSE omits a lot of the detail which larger companies have to include in the notes to the accounts.
A multitude of partners
One company is neither a public nor private limited company despite having a turnover of over £6 billion. The founder of the John Lewis Partnership, John Spedan Lewis, wanted to create a company that combined a staff-friendly environment with a commercial edge that would allow it to move quickly and stay ahead in a competitive industry. All 68,000 permanent staff are Partners owning 26 John Lewis department stores, 183 Waitrose supermarkets, an online and catalogue business, and more. Its constitution is a democratic one giving every Partner a voice in the business they co-own – an unusual combination of commercial acumen and corporate conscience. Partners share in the benefits and profits of a business that is dedicated to putting them first.
Understanding Public (Listed) Companies
A company that offers shares on the open market is a public or listed company. Public-company owners don’t make decisions based solely on their preferences. They must always consider the opinion of the company’s outside investors.
In the UK, there are three markets where shares can be traded:
London Stock Exchange – Main Market: This is the market for the established company. It has the most onerous requirements as concerns standards of corporate governance and reporting. For the rest of this chapter, whenever we refer to public companies, we mean companies listed on the Main Market.
London Stock Exchange – Alternative Investment Market (AIM): AIM offers all the benefits of being traded but within a regulatory environment designed specifically for smaller companies. There are no minimum criteria covering size, track record, or number of shares which need to be available to the public. A company wishing to join AIM must appoint a nominated advisor (Nomad) from a list of such advisors approved by the market. The Nomad will ensure that the company is suitable for AIM and ready to be admitted to a public market. AIM is seen as the best market for the smaller but growing company.
PLUS: Plus Markets Group (PMG) is an independent provider of primary and secondary market services and currently trades over 850 small and mid-capitalised company shares. To be traded on PLUS, the company may already be listed on AIM or the Main Market – in which case, the PLUS market offers an alternative trading platform offering greater market exposure, Alternatively, the company may float on PLUS and therefore be traded on PLUS. The key difference from trading on the London Stock Exchange is that buying and selling shares on PLUS is supported by a quote-driven equity trading system. Market makers will quote the price at which they are prepared to deal and this is then transmitted to the market. Deals can then be executed immediately. Competing market makers should improve the prices that can be obtained and offer improved liquidity in shares that might otherwise be difficult to trade on the other markets.
Meeting filing requirements
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 generates at least £10–20 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 company 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 company 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 company afford the ongoing cost of financial reporting and auditing requirements?
If company owners are confident in their answers to these questions, they may want to take their company public. But they need to keep in mind the advantages and disadvantages of going public. Going public is a long, expensive process that takes months, or even years.
Companies don’t take themselves public alone. They hire investment bankers to steer the process to completion. Investment bankers usually get multimillion-pound fees or commissions for taking a company public. We talk more about the process in the upcoming section ‘A Whole New World: How a Company Goes from Private to Public’.
Going public, losing jobs
Public company founders who don’t keep their investors happy can find themselves out on the street and no longer involved in the company that they started. Steve Jobs and Steve Wozniak, who started Apple Computer, found out the hard way that selling shares on the public market can ultimately take the company away from the founders.
Jobs and Wozniak became multimillionaires after Apple Computer went public, but shareholders ousted them from their leadership roles in a management shake-up in 1984 following an industry-wide sales slump towards the end of 1984 and Wozniak decided to leave Apple soon after the shake-up. Apple’s new CEO announced that he couldn’t find a role for Steve Jobs in the company’s operations in 1985.
Interestingly, Steve Jobs ended up as the head of Apple again in 1998, when the shareholders turned to him to try to rescue the company from failure. He has since engineered a comeback for Apple.
Examining the perks
If a company goes public, the primary benefit is that it gains access to additional capital (more cash), which can be critical if it’s a high-growth company that needs money to take advantage of its growth potential. A secondary benefit is that company owners can become millionaires, or even billionaires, overnight if the initial public offering (IPO) is successful. When Google announced its decision to go public, initial news reports indicated that the IPO was expected to net $2.7 billion for the company and its small circle of investors.
Being a public company has a number of other benefits:
New corporate cash: At some point, a growing company usually maxes out its ability to borrow funds, and it must find people willing to invest in the company. Selling shares to the general public can be a great way for a company to raise cash without being obligated to pay interest on the money.
Owner diversification: People who start a new business typically put a good chunk of their assets into starting the business and reinvest most of the profits earned in the business in order to grow the company. Frequently, founders have a large share of their assets tied up in the company. Selling shares publicly allows owners to take out some of their investment and diversify their holdings in other investments, which reduces the risks to their personal portfolios.
Increased liquidity:
Liquidity is a company’s ability to quickly turn an asset to cash if it isn’t already cash. People who own shares in a closely held private company may have a lot of assets but little chance to actually turn those assets into cash. Selling privately owned shares is very difficult. Going public gives the shares a set market value and creates more potential buyers for the shares.
Company value: Company owners benefit by knowing their company’s worth for a number of reasons. If one of the key owners dies, a value must be placed on the company for inheritance tax purposes. If these values are set too high for private companies, this can cause all kinds of problems for other owners and family members. Going public sets an absolute value for the shares held by all company shareholders and prevents problems with valuation. Also, companies that want to offer shares to their employees as incentives find that recruiting with this incentive is much easier when the shares are traded on the open market.
Looking at the negative side
Regardless of the many advantages of being a public company, a great many disadvantages also exist:
Costs: Paying the costs of providing financial statements that meet the appropriate requirements can be very expensive. Investor relations can also add significant costs in employee time, printing, and mailing expenses.
Control: After the shares are traded on the open market, it would be unusual for the original owners and investors to retain enough shares to keep absolute control of the company. As shares sell on the open market, more and more shareholders enter the picture, giving each one the right to vote on key company decisions.
Disclosure: Competitors can access detailed information about a public company’s operations by getting copies of the required public financial reports. Although a private company can hide difficulties it may be having, a public company must report its problems, exposing any weaknesses to competitors. In addition, the net worth of a public company’s owners is widely known because their holdings of stock must be disclosed as part of these reports.
Cash control: In a private company, the owner’s salary and benefits – as well as the salary and benefits of any family member or friend involved in running the company – can be decided on by the owner independently. In a public company, the remuneration committee – usually made up of non-executive directors – has to approve and report salary and other benefits of the directors. Public companies are not permitted to give loans to directors or their families.
Lack of liquidity: When a company goes public, a constant flow of buyers for the shares isn’t guaranteed. In order for a share to be liquid, a shareholder must be able to convert shares into cash. Small companies that don’t have wide distribution of their shares can find that selling them on the open market is difficult. The market price may even be lower than the actual value of the company’s assets because of a lack of competition for shares. When not enough competition exists, shareholders have a hard time selling their shares and converting them to cash, making the investment non-liquid.
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Filing and more filing: Government and shareholder reports
Just as private companies must file their financial statements at Companies House (see the section ‘Investigating Private Companies’, earlier in this chapter), public companies must fulfil the same requirements.
For public companies that are not listed there are only a few additional requirements when compared with private companies. However, listed public companies have to provide a lot more information to their shareholders and the market. The requirements vary somewhat between the three markets but the key continuing obligations of companies listed on the Main Market can be summarised as follows:
The company must comply with the Combined Code on Corporate Governance – or explain why they do not. The Combined Code is so called because it is based on the recommendations over the years of a number of committees starting with the Cadbury Committee in 1992. It is now produced and monitored by the Financial Reporting Council (FRC) and includes requirements such as:
• The chairman should not also be the chief executive.
• Non-executive directors should be appointed so that a balanced board is achieved.
• Directors’ remunerations should be set by a remuneration committee consisting of non-executive directors.
• The board should maintain a sound system of control to safeguard shareholders’ investments and the company’s assets.
An audit committee should be established consisting of non-executive directors.
The company must publish:
• Interim statements – currently at the half-year stage. Interim statements should contain the main financial statements – balance sheet, summarised income statement, cash-flow statement, statement of changes in equity – and a commentary on the results. Interim statements do not need to be audited. The Transparency Directive, which has recently been introduced into UK law adds new requirements for quarterly statements.
• Annual report and accounts – which are covered in great detail in chapters 5 to 10 of this book. Prior shareholder approval must be obtained for Class 1 transactions – these occur if the company acquires or disposes of a major asset (such as a subsidiary company) where the amounts involved exceed 25 per cent of a range of financial indicators. Prior approval is also required for certain employee share schemes.
Shareholders must be informed of Class 2 and Class 3 transactions which are similar to Class 1 but where the amounts involved are less.
The company must comply with the Model Code which is part of the FSA’s listing rules. The Model Code lays down the rules concerning when directors and others can deal in the company’s shares. These rules are designed to stop insider dealing. Insider dealing is the name given to the situation where an individual, being aware of inside information which if it were known to the public at large would affect the share price of the company, uses that information to gain an unfair advantage over other investors.
Directors must notify the company of dealings in the company’s shares and these must be reported to the market as soon as possible.
Shareholders owning more than 3 per cent of the shares of the company must notify the company of that fact and this must be reported to the market.
The Sarbanes-Oxley Act
The Sarbanes-Oxley Act is a bill passed by Congress in the US in 2002 in the wake of various corporate scandals such as Enron and Tyco. This bill affects any UK company with a listing in the US. It has added significant costs to the entire process of completing financial reports, affecting the following components:
Documentation: Companies must document and develop policies and procedures relating to their internal controls over financial reporting. Although an outside accounting firm can assist with the documentation process, management must be actively involved in the process of assessing internal controls. They can’t delegate this responsibility to an external firm.
Audit fees: Independent audit firms now look a lot more closely at the financial statements and the internal controls in place over financial reporting, and the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) now regulate the accounting profession in the US. The PCAOB inspect accounting firms annually to be sure that they’re in compliance with the Sarbanes-Oxley Act and SEC rules. These inspections have increased audit fees substantially.
Legal fees: Because companies need lawyers to help them comply with the new provisions of the Sarbanes-Oxley Act, their legal expenses are increasing.
Information technology: Complying with the Sarbanes-Oxley Act requires both hardware and software upgrades to meet the internal control requirements and the speedier reporting requirements.
Board of directors: Most companies must restructure their board of directors and audit committees to meet the requirements of the Sarbanes-Oxley Act, ensuring that independent board members control key audit decisions. The structure and operation of nominating and compensation committees must eliminate even the appearance of conflicts of interest. Companies must make provisions to give shareholders direct input in corporate governance decisions. Companies also must provide additional education to board members to be sure that they understand their responsibilities to shareholders.
The rules imposed by Sarbanes-Oxley may be such a significant burden on small companies in the US that a number of them may decide to buy out shareholders and make the companies private again, merge with larger companies, or even liquidate. If a private company is considering the possibility of going public, it may decide that the process isn’t worth the costs.
As regards UK companies, they may decide to de-list from the US stock exchange to avoid the need to comply with Sarbanes-Oxley.
A Whole New World: How a Company Goes from Private to Public
So a company has finally decided to sell its stock publicly. Now what? In this section we describe the role of an investment banker in helping a company sell its stock. We also explain the timetable for listing.
1. Shareholder approval needs to be obtained.
2. The issued share capital of the company must be at least £50,000 – although only a quarter of this needs to be paid up.
3. The most recent accounts of the company must show that the capital has not been eroded by losses.
4. When all the documents have been delivered to the registrar then the company’s name is changed to end with those three special letters – PLC.
Teaming up with an investment banker
A major step for a company deciding to go public is to choose who will handle the sales and which market to sell the stock on. Few firms have the capacity to approach the public stock markets on their own. Instead, they hire an investment banker or other advisor to help them through the complicated process of going public. A well-known investment banker can help lend credibility to a little-known small company, which makes selling the stock easier.
Investment bankers help a company in the following ways:
They prepare the required documents and the prospectus for the sale of shares. There are very detailed requirements as to the contents of the prospectus. It will include, for example, information about the company (its products, services, and markets) and its officers and directors. Additionally, information must be given about the risks the company faces; how the company plans to use the money raised; any outstanding legal problems; holdings of company insiders; and, of course, audited financial statements.
They price the shares to be attractive to potential investors. If the shares are priced too high, the offering could fall flat on its face, with few shares sold. If priced too low, the company could miss out on potential cash that investors, who buy IPO shares, can get as a windfall from quickly turning around and selling the shares at a profit.
They negotiate the price at which the shares will be offered to the general public and the guarantees the investment banker will give to the company owners for selling the stock. An investment banker can give an underwriting guarantee, which guarantees the amount of money that will be raised. In this scenario, the banker buys the shares from the company and then resells them to the public. Usually, an investment banker puts together a syndicate of investment bankers that helps find buyers for the stock.
Another method that’s sometimes used is called a best efforts agreement. In this scenario, the investment banker tries to sell the stock but doesn’t guarantee the number of shares that will sell.
They decide which stock exchange to list the stock on. The Main Market has the highest level of requirements. If a company wants to list on this exchange, it must normally have a minimum market capitalisation of £700,000, at least 25 per cent of the shares must be in public hands and it would normally have at least a three-year trading record. AIM and PLUS have lower requirements.
Timetable for listing
In their guide to joining the Main Market, the London Stock Exchange sets out a timetable for listing. They describe the main activities in each phase as follows:
Pre-float preparation:
36–24 months: Develop a robust business plan and a detailed review of ownership and tax issues, customer/supplier contracts, management information systems, and operational and compliance controls.
24–12 months: Acquire information about what a Main Market flotation involves, review corporate governance, and complete any strategic initiatives or acquisitions.
12–6 months: Develop an investor relations strategy and ensure that the necessary financial statements and non-executive directors are in place. Decide on the method of flotation and interview potential advisors.
The listing process:
6–3 months: Appoint and instruct advisors and agree on the timetable.
12–6 weeks: The company and its advisors review pricing issues, host analyst presentations and produce drafts of key documents – including the prospectus.
6 weeks–1 week: UKLA sees and approves all documents. The company and advisors complete their checking of the documentation, hold PR meetings and analyst roadshows.
1 week–admission: The company makes its formal application for listing and admission. Once this is granted trading begins.