Reading Financial Reports for Dummies (9 page)

In this chapter, I 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 a company’s financial reporting requirements. I also describe the process involved when company owners decide to take their business public.

Investigating Private Companies

Private companies
don’t sell stock to the general public, so they don’t have to report to the government (except for filing their tax returns, of course) or answer to the public. No matter how big or small these companies are, they can operate behind closed doors.

A private company gives owners the freedom to make choices for the firm 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 — either through profits, debt funding, or investments from family and friends.

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Part I: Getting Down to Financial Reporting Basics
Keeping it in the family

Mars, one of the world’s largest private compa-

information technology related to its manufac-

nies, makes some of your favorite candies — 3

turing operations. The family is still in control of

Musketeers, M&M’s, and Snickers. Mars has

all these businesses and makes the decisions

never gone public, which means it has never

about which businesses to add to its portfolio.

sold its shares of stock to the general public.

One of Mars’s five key principles that shape

The company is still owned and operated by the

its business is “Freedom.” The company’s

family that founded it.

statement about the importance of freedom

Frank and Ethel Mars, who made candy in the

clearly describes why the family decided to

kitchen of their Tacoma, Washington, home, stay private: started Mars in 1911. Their first worldwide suc-Mars is one of the world’s largest privately

cess was the Milky Way bar, which became

owned corporations. This private owner-

known as the Mars bar in Europe in the 1920s.

ship is a deliberate choice. Many other

Today, Mars is a $25 billion business with oper-

companies began as Mars did, but as they

ations in more than 56 countries and sales of its

grew larger and required new sources of

products in over 100 countries. Mars isn’t just

funds, they sold stocks or incurred restric-

making candy anymore, either. It also manu-

tive debt to fuel their business. To extend

factures Whiskas and Pedigree pet food, Uncle

their growth, they exchanged a portion of

Ben’s rice products, vending systems, elec-

their freedom. We believe growth and pros-

tronics for automated payment systems, and

perity can be achieved another way.

Checking out the benefits

Private companies maintain absolute control over business operations. With absolute control, owners don’t have to worry about what the public thinks of its operations, nor do they have to worry about the quarterly race to meet the numbers to satisfy Wall Street’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

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Confidentiality:
Private companies can keep their records under wraps, unlike public companies, which must file quarterly financial statements with the Securities and Exchange Commission (SEC) and various state agencies. Competitors can take advantage of the information that public companies disclose, whereas private companies can leave their competitors guessing and even hide a short-term problem.

Chapter 3: Public or Private: How Company Structure Affects the Books
31

Owners of private companies also like the secrecy they can keep about their personal net worth. Although public companies must disclose the number of shares their officers, directors, and major shareholders hold, private companies have no obligation to release these ownership details.

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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, 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. A private-company owner can take out whatever money he wants 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.

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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:

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Arrange for a loan with a financial institution

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Sell additional shares of stock to existing owners

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Part I: Getting Down to Financial Reporting Basics

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Ask for help from an
angel
, a private investor willing to help a small business get started with some upfront cash

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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

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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 — 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 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.

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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.

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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 business that they do.

Another major disadvantage that a private company faces is that the owners’

net worth is likely tied almost completely to the value of the company. If a business 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 stock and diversify their portfolios, thereby reducing their portfolios’ risk.

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.

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Private or Publix?

Publix Super Markets is a private company public offerings that are open only to its employ-owned by more than 87,000 shareholders. ees and non-employee members of its board of You can think of it as a semi-public company.

directors. It also offers employees a stock own-

However, until Publix actually decides to sell

ership plan, which has more than 92,000 partici-

stock on a public exchange — if it ever does —

pants. So even though Publix stock isn’t sold on

it’s classified as a private company. Publix a stock exchange, Publix must file public finan-makes its stock available during designated cial reports with the SEC.

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.)

When a private company’s stock ownership and assets exceed the limits set by the Securities and Exchange Act of 1934, the company must file a Form 10, which includes a description of the business and its officers, similar to an initial public offering (also known as an IPO, which is the first public sale of a company’s stock). After the company files Form 10, the SEC requires it to file quarterly and annual reports.

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.

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Part I: Getting Down to Financial Reporting Basics
Going public, losing jobs

Public company founders who don’t keep their

in a management shake-up in 1984. Wozniak

investors happy can find themselves out on the

decided to leave Apple soon after the shake-up.

street and no longer involved in the company

Apple’s new CEO announced that he couldn’t

they started. Steve Jobs and Steve Wozniak,

find a role for Jobs in the company’s operations

who started Apple Computer, found out the in 1985.

hard way that selling stock on the public market

Interestingly, Jobs ended up as the head of

can ultimately take the company away from the

Apple again in 1998, when the shareholders

founders.

turned to him to try to rescue the company from

Jobs and Wozniak became multimillionaires failure. He has since engineered a comeback after Apple Computer went public, but share-for Apple.

holders ousted them from their leadership roles

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:

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Can my firm maintain a high growth rate to attract investors?

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Does enough public awareness of my company and its products or services exist to make a successful public offering?

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Is my business operating in a hot industry that will help attract investors?

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Can my company perform as well as, and preferably better than, its competition?

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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.

Companies don’t take themselves public alone — they hire investment bankers to steer the process to completion. Investment bankers usually get multimillion-dollar fees or commissions for taking a company public. I talk more about the process in the upcoming section “A Whole New World: How a Company Goes from Private to Public.”

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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 business 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.

Being a public company has a number of other benefits: