In a recent New York Times article, Steven Davidoff Solomon listed several possible explanations for a significant decline in the number of initial public offerings (IPOs). Among the most interesting was that there are many large and successful high-tech acquirers such as Facebook, Google, and Microsoft that are willing to pay top dollar for high flying unicorns (private companies with equity values greater than $1 billion) before they become public companies. The ability of the private markets to provide financing may have matured to the point where the advantages of financing through the public markets are no longer as great. Shareholder activism may also be scaring off companies that would normally enter the public markets. The relatively low number of IPOs over the last several years is simply a reversion back to what we should consider to be normal, perhaps 150 per year but with lots of volatility in that number.
I would like to add another possible explanation: the reduced ability of corporations to take advantage of private ordering once they become a public company. Private ordering of governance arrangements can be a wonderful thing. As observed by former SEC Commissioner Troy A. Paredes, it “allows the internal affairs of each corporation to be tailored to its own attributes and qualities, including its personnel, culture, maturity as a business, and governance practices.” Bargaining is the key to private ordering as “observed governance choices are the result of value maximizing contracts between shareholders and management.”
Shareholders, the sole claimants to a firm’s residual cash flow, would argue that any new corporate governance arrangements resulting from an IPO should be aimed at maximizing their wealth, because they are the company stakeholders least protected by contract. That is, they are the parties to the corporate contract that have the greatest risk of ending up with nothing as a result of their dealings with the corporation.
Of course, the pricing of an IPO is central to allowing private ordering and prompting optimal corporate governance arrangements. When bargaining results in arrangements that do not maximize shareholder wealth, insiders and the company pay a price, pressuring them to move toward arrangements that enhance value for all parties. That is, the offering price and future trading price of the stock will need to be adjusted downward if the optimal corporate governance arrangements are not implemented up-front. Insiders as stockholders won’t make as much money and the company will raise less money through the IPO. Conversely the offering price in an IPO will be highest when the optimal arrangements are selected.
For example, in the context of offering dual class shares in an IPO, “If investors’ value voting rights and a firm fails to provide them, then the firm’s securities simply sell at a lower price,” writes Daniel Fischel. In sum, the market provides sufficient incentives and penalties to make sure the bargaining for corporate governance arrangements moves toward wealth maximization.
Unfortunately, more and more public companies are being pressured by shareholder activists, institutional investors, proxy advisory firms, and government regulators to take a one-size-fits-all approach, something that is contrary to private ordering and the ability of corporate governance arrangements to enhance shareholder wealth. As a result, there has been a steady decline in public companies’ ability to implement governance arrangements in the IPO process or maintain them post-IPO, arrangements such as classified/staggered boards, plurality voting, a significant number of insiders on the board, one person serving as chairman of the board and CEO, proxy access initiated by the board rather than shareholders, and dual class share structures created when a company goes public, as became apparent after Snap Inc.’s IPO. Companies that remain private could implement any of these arrangements.
If companies are limited in bargaining for governance arrangements or forced to drop the arrangements after an IPO, we can expect more private companies to delay going public. The initiation fee for entry into the public company club has clearly gone up.
This post comes to us from Bernard S. Sharfman, who is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, a visiting professor at the University of Maryland School of Law (Spring 2018), and a former visiting assistant professor at Case Western Reserve University School of Law (Spring 2013 and 2014). Mr. Sharfman’s articles on corporate law and governance can be found here.