Insider Ownership and the Decision to Go Public

Abstract

This paper focuses on the role of an initial offering (IPO) in maximizing the proceeds an initial owner obtains in selling his company. In deciding whether to undertake an IPO, and what fraction of ownership to retain, the initial owner must balance two factors. By selling to dispersed shareholders, he maximizes his proceeds from the sale of cash flow rights. However, by directly bargaining with a potential buyer, he maximizes his proceeds from the sale of control rights. Whether a company should be private or public, as well as the insider's ownership in companies, depends on the particular combination of majority control and dispersed ownership which maximizes the incumbent's wealth. The model provides implications on the strategy to be followed in selling a company as well as on the timing of IPOs and going-private transactions. The initial offering (IPO) is frequently the largest equity issue a corporation ever makes. Every year an average of one-third of all the funds raised through common equity is raised through IPOs. The IPO is also an important channel through which an entrepreneur or venture capitalist gets rewarded for his initial effort. Our understanding of the process of public is critical to any attempt both to increase equity financing and to stimulate entrepreneurial and venture capitalist activities. The latter has been stated as an objective in the policy debate over the capital gains tax (see Poterba (1989)). Until the beginning of the 1980's the decision to go was considered a simple stage in the growth process of a corporation. This interpretation can no longer hold. In the 1980's the U.S. experienced a major wave of large and mature firms going private. The result was that, despite a growing economy and a long bull market, in the 1980's the U.S. share in world market capitalization shrank from 53.3% to 29.9%. Very little is known about why companies choose to revert back to private ownership and whether this is a temporary or a permanent situation. According to Kaplan (1991) these neo-private companies are neither short lived nor permanent. He estimates that only 50% of large leveraged buyouts (LBO) become again within seven years after the LBO transaction. Furthermore, 7% of those companies in his sample that returned to offering went private again later. Starting with Pagano (1993), existing models emphasize some aspects of the traditional trade-off between the costs and benefits of going public.' On the cost side, there are the registration and underwriting costs (on average 14% of the funds raised, according to Ritter (1987)), the underpricing cost (on average 15%, Ritter (1987)), the annual disclosure costs, and the agency problems generated by a separation between ownership and control (Jensen and Meckling (1976)). On the benefit side, there are diversification, the possibility of equity financing beyond the initial entrepreneur's limited wealth, a less costly access to