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Going Public: How Initial Public Offerings Work


Why does a company like Walt Disney sell shares of itself to investors? To answer that question, consider the following.

Let's say that you're the manager of a department store, and one day you decide to go into business for yourself and open your own store. It takes money to start such a business, to acquire a building, to stock inventory for your shelves, to hire personnel, to advertise your new business, and to pay the myriad other costs involved with the operation of your business.

Where do you get the money to pay all those expenses? You have a couple of options:

  • You could use your own savings.
  • You could borrow from the bank, friends, or family and pay back the loan with interest.
  • You could sell a stake in the business to a partner who would run the business with you, sharing in any profits (as well as any losses).

These are all sources of capital, and are essentially the same ways that corporations like McDonald's, Exxon, American Express, and Sears-Roebuck finance their operations, albeit on a much bigger level.

You're able to get your new business up and running with your own savings and with some funds you borrow from the bank. Business is good, and your new store is popular. In a few years, you're able to build and operate a few more stores. As you expand, you also build bigger stores, until finally you're sitting on a little retail empire. Your 18 stores are generating sales of $44 million a year.

It's clear you're onto a big new concept in retailing, one that America is ready for. You're ready to take your chain to a national level, but as you look at the costs of building hundreds of stores across the country, it's amazing how much more capital you'll need.

While you could go back to the bank and ask for a big loan, you see a couple of problems with that plan. First, banks want to guarantee (as much as they possibly can) that they'll eventually be repaid. Not only do they want collateral and a solid business plan, but they also have the ability to foreclose on your loan if you fall behind on payments. A few bad months and the bank could be knocking on your door with a foreclosure notice. Banks also charge interest -- that's how they make their money, after all -- but those interest payments could have a serious drain on your cash flow in the crucial expansion stage of your business.

The next step, then, is to turn to people outside your company and ask them to invest in your business. In return for their investment, you will give them a piece of your company. If the company were profitable, it would be eligible to share in those profits with you. They would also have some say in the operation of your business.

You could raise funds from private investors. This is often known as venture capital -- firms and individuals that specialize in investing in other businesses.

But you could also go public. You will offer shares of your company for sale to the public, in the form of stock that trades on a stock exchange. This sale of stock is your initial public offering, and the proceeds from the sale go into your company's bank account, after you pay the investment bankers who helped manage the offering.

Your new shareholders will each own a piece of your business, and will be able to elect a Board of Directors to oversee the management of your business. (Of course, you will probably maintain a majority stake in your business, and have some pull in the nomination and election of the Board's directors and officers.)

By the way, the above story is essentially the tale of how a pickup truck-driving small businessman in Arkansas named Sam Walton turned a small chain of stores into one of the biggest companies in the U.S -- Wal-Mart.