Moving towards an initial public offering often seems like a great idea. It allows founders, employees, and investors to cash out, and is a significant source of new funding.But there’s a downside too, according to a working paper from John Asker and Alexander Ljungqvist of NYU’s Stern School of Business and Joan Farre Mensa of Harvard Business School—and it goes beyond the possibility of an embarrassing Facebook or Groupon style collapse.
The economists found that a private company will invest 10 per cent of its total assets each year, compared to just 4 per cent for a comparable public company.
Additionally, private companies are 3.5 times more responsive to changes in the investment environment than those that have gone public.
Private companies invest more and better take advantage of available opportunities.
The authors propose that this gap is caused by differing incentives for managers. If a manager of a public company benefits from higher stock prices via stock grants or job security, they’re more likely to value near term profit over long term investment.
The belief that investors undervalue long term investment adds to the problem. Even if a particular investment is better for the long term performance of a company, managers will tend to value more immediately visible actions.
They want to make things easier on themselves, avoiding criticism from investors this quarter at long term cost to the company.
Private companies avoid this because their ownership is (usually) concentrated in just a few hands. There’s closer review of managerial decisions, and no need to appeal to the immediate desires of the stock market.
This is especially important in today’s economy where private companies, entrepreneurs, and tech savvy venture capitalists are looking for ways to disrupt larger companies or beat them by being more agile.
It also points out a significant problem in corporate culture. The pressure to outperform expectations every single quarter or face the wrath of analysts and investors leads to poorer long term decision making.
The ability to successfully communicate a long term strategy to a huge array of stakeholders, actually execute it, and keep the market happy is a balancing act for public companies. The ones that manage it outperform for years at a time rather than quarters.
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