Defining an IPO (Initial Public Offering)
An initial public offering (IPO) is the procedure of releasing fresh shares of stock to the public for the first time in a private firm. A corporation can raise equity funding from the general public through an IPO.
Since there is often a share premium for present private investors, the transition from a private to a public firm can be a crucial period for private investors to completely realize rewards from their investment. Additionally, it enables public investors to take part in the sale.
How do they work?
Most businesses find it tough to handle the lengthy, laborious process of going public on their own. In addition to preparing for an exponential rise in public scrutiny, a private firm seeking an IPO must also submit a massive amount of paperwork and financial disclosures in order to comply with the Securities and Exchange Commission's (SEC) rules governing public corporations.
Because of this, a private company that intends to go public employs an underwriter—typically an investment bank—to provide advice on the IPO and aid in the determination of the offering's starting price. A roadshow is a meeting with potential investors that is scheduled by underwriters to help management get ready for an IPO.
According to Robert R. Johnson, Ph.D., a chartered financial analyst (CFA) and professor of finance at the Heider College of Business at Creighton University, "The underwriter puts together a syndicate of investment banking firms to ensure extensive distribution of the new IPO shares." A percentage of the shares will be distributed by each investment banking firm in the syndicate.
The underwriter issues share to investors once the firm and its advisors have decided on an initial price for the IPO, and the company's stock then starts trading on a public stock market like the New York Stock Exchange (NYSE) or the Nasdaq.
Why consider an IPO?
Although an initial public offering (IPO) may be the first opportunity for the general public to purchase shares of a company, it's crucial to realize that one of the IPO's goals is to enable early investors in the company to withdraw their capital.
Think of an initial public offering (IPO) as the conclusion of one stage in a company's life cycle and the commencement of another because many initial investors desire to sell their shares in a start-up or new business. As an alternative, shareholders in more mature private companies planning to go public may also seek the chance to sell some or all of their shares.
According to Matt Chancey, a certified financial planner (CFP) in Tampa, Florida, "the reality is that there is a friend and family round, and there are some angel investors that got in first." Before a firm eventually goes public, a lot of private money—like money from Shark Tank—is invested in it.
Other factors for pursuing an IPO include cash raising or increasing a company's visibility in the public:
- Shares can be sold to the general public to help businesses raise more money. The money raised could be put to good use by financing business growth, R&D, or debt repayment.
- It can be too expensive to use other methods of fundraising, such as bank loans, venture capitalists, and private investors.
- Companies can receive a ton of publicity by going public through an IPO.
- Companies may desire the prestige and stature that come with becoming publicly traded companies, which may also enable them to negotiate better loan terms.
Going public may make it simpler or less expensive for a business to raise funds, but it also complicates a lot of other issues. It is necessary to disclose information, for example, by publishing quarterly and annual financial reports. In addition to having to record actions like top executives trading stocks or exploring acquisitions, they also have to answer to the shareholders.
What are the steps involving an IPO?
There are essentially two steps in the IPO process. The pre-marketing stage of the offering is the first, and the actual initial public offering is the second. A company that wants to go public will either request private bids from underwriters or make a public announcement to pique interest.
The corporation selects the underwriters, who oversee the IPO process. A business may select one or more underwriters to oversee certain phases of the IPO process jointly. Every step of the IPO process, including due diligence, document preparation, filing, marketing, and issuance, is handled by the underwriters.
Steps to an IPO
Proposals
The appropriate type of security to issue, the offering price, the number of shares, and the anticipated time frame for the market offers are all discussed in the proposals and valuations that the underwriters submit.
Underwriter
Through an underwriting agreement, the corporation selects its underwriters and formally accepts to underwrite terms.
Team
Underwriters, attorneys, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) specialists constitute IPO teams.
Documentation
The company's information is gathered for the necessary IPO paperwork. The main IPO filing document is the S-1 Registration Statement. The prospectus and the privately held filing information make up its two components.
The S-1 contains a preliminary description of the anticipated filing date. It will go through numerous revisions during the pre-IPO process. The prospectus that is presented is also updated frequently.
Promotion & Updates
For the pre-marketing of the new stock issuance, marketing materials are prepared. To determine a final offering price and gauge demand, management and underwriters publicize the share issuance. In the course of the marketing process, underwriters are permitted to modify their financial analysis. This may entail altering the IPO price or the issue date if necessary. Companies take the appropriate actions to satisfy particular requirements for public share offerings. Both SEC standards for public firms and exchange listing requirements must be followed by businesses.
Board & Processes
Create a board of directors and make sure that procedures are in place for reporting quarterly auditable financial and accounting data.
Issued Shares
On the IPO date, the company issues its shares. The balance sheet's stockholders' equity is represented on the statement of cash received from the primary issuance of capital to shareholders. The value of each share on the balance sheet is then entirely based on the shareholders' equity per share valuation of the corporation.
Post-IPO
There might be some post-IPO provisions put in place. Following the day of the initial public offering (IPO), underwriters might have a set period of time in which to purchase more shares. During this time, certain investors can experience calm periods.
Pros & Cons of an IPO
An IPO's main goal is to help businesses raise finance. It may also have additional benefits in addition to drawbacks.
Advantages
One of the main benefits is that the company can raise money by accepting investments from the entire investing public. This makes acquisition deals (share conversions) simpler to complete and improves the company's visibility, reputation, and public image, all of which can boost sales and profitability.
A firm can typically benefit from more favorable credit borrowing conditions than a private company thanks to the increased transparency that comes with compulsory quarterly reporting.
Disadvantages
Companies may encounter a number of drawbacks to going public and may decide to adopt alternative tactics. One of the biggest drawbacks is the high cost of initial public offerings (IPOs), as well as the continuous and frequently unrelated costs of sustaining a public company.
For management, which may be paid and assessed largely on stock performance rather than actual financial results, fluctuations in a company's share price can be a distraction. The business must additionally publish financially, accounting, tax, and other business data. It might be forced to publicly divulge trade secrets and business strategies during these disclosures, which could give rivals an advantage.
It may be more challenging to keep competent managers who are prepared to take chances if the board of directors has rigid leadership and governance. There is always the option to keep things secret. Companies may also request bids for a takeover rather than going public. In addition, businesses could look into several alternatives.
Pros
- Future secondary offerings may be used to raise further capital.
- Through involvement in liquid stock equities, better management and skilled staff are attracted and retained (e.g., ESOPs).
- A company's cost of capital for both equity and debt may be reduced as a result of IPOs.
Cons
- Costs for marketing, accounting, and law are significant and frequently continuing.
- Management must devote more time, effort, and attention to reporting.
- A loss of control and more serious agency issues are present.
What are your other options?
Direct Listing
When there are no underwriters involved, the IPO is referred to as a direct listing. Direct listings omit the underwriting step, putting the issuer at greater risk if the offering fails, but they also may result in higher share prices for the issuer. A direct offering is typically only possible for a business with a strong brand and a lucrative industry.
Dutch Bidding
A Dutch auction does not establish an IPO price. Shares can be bid on by interested buyers, along with their desired price. The available shares are subsequently distributed to the bidders who offered the highest price.
Factors that determine the success of an IPO
The return from an IPO, which is frequently closely watched by investors, can be impacted by a number of factors. Investment banks may overhype some IPOs, which can result in initial losses. However, when they are made available to the public, the bulk of IPOs are renowned for increasing short-term trading. The performance of IPOs depends on a few important factors.
Lock-Up
If you examine the charts after many IPOs, you'll see that the stock has a sharp decline after a few months. This frequently occurs as a result of the lock-up period expiring. The underwriters need corporate insiders, including as executives and staff, to sign a lock-up agreement before a firm goes public.
Lock-up agreements
Lock-up agreements are enforceable arrangements that forbid insiders of the company from selling any shares of stock for a predetermined period of time. Three to 24 months are possible as the timeframe. The minimum lock-up time stipulated by Rule 144 (SEC rule) is ninety days, although the underwriters may choose a lock-up time that is significantly longer. 4 The issue is that all insiders are allowed to sell their stock after lockups expire. As a result, there is a rush of individuals wanting to sell their stock in order to make a profit. The stock price may face intense downward pressure as a result of this surplus supply.
Awaiting Times
In the terms of their offerings, certain investment banks contain waiting periods. This reserves a certain number of shares for purchase at a later time. If the underwriters decide not to purchase this allocation, the price could drop.
Flipping
The act of "flipping" involves reselling an IPO share within a short period of time in order to make a quick profit. It frequently happens when a stock is discounted and then surges on its first trading day.
Monitoring IPO Stocks
When an existing firm spins out a division of the business as a separate legal organization, creating tracking stocks, it is closely akin to a standard IPO. The idea behind tracking stocks and spin-offs is that occasionally, a company's many divisions may be worth more as a separate entity than as a whole. For instance, if a segment within an otherwise slowly expanding firm has a high growth potential but big current losses, it would be profitable to carve it out, keep the parent company as a significant shareholder, and then allow it to raise extra capital through an IPO.
These IPO chances can be intriguing from the standpoint of an investor. Investors typically learn a lot about the parent firm and its ownership share in the divesting company through a spin-off of an established business. More information is typically preferable than less when it comes to educating potential investors, therefore astute investors may find fantastic chances in this kind of scenario. Because investors are generally better knowledgeable, spin-offs typically experience less initial volatility.
IPO Pricing
The process of an initial public offering (IPO) often starts with the company hiring one or more investment banks to assist in setting the share price. A preliminary prospectus and registration statement (or S-1) outlining the company's business strategy and plans for the raised capital is then published by it.
The company and its banks can then organize a roadshow to speak with institutional investors, analysts, hedge funds, and fund managers about the business strategy in order to gauge their interest in purchasing the stock. This aids in determining the share price for the business and its bankers.
The corporation makes new shares available to offer on stock markets once the initial stock price has been established. The corporation receives money from investors who have bought its shares as payment for them.
The majority of investors (with the exception of a few corporate insiders who are subject to limitations) are free to buy and sell shares of the firm's stock after the IPO on the secondary market.
An IPO listing – the day of
Any stock investment carries the danger of the share price increasing or decreasing, but this is particularly true on List Day. Shares start trading on open markets, initially at the final IPO price and later at any time based on investor demand.
In the US, stock trading starts at 9:30 a.m. ET (when the market opens). However, because to pent-up demand and a small share supply, list day trading for an IPO often doesn't start until much later. Investors can start buying and selling shares of the new company through your brokerage firm as soon as trading starts.
Risks involving an IPO
All stock trading carries some risk, particularly with shares of recently listed firms.
- Hype can increase volatility:
A company's leadership or bank underwriters may make unduly optimistic or pessimistic pronouncements in the early days of trading, and there is frequently media attention surrounding an IPO. Due to the increased volatility caused by this increased focus, the share price may change significantly in a single day.
- The stock price may be protected by investment banks:
The bank underwriters are permitted to prevent a steep decline in the stock price in the days after an IPO. They might even invest in shares of the newly listed business. The stock price may drop below the offering price if this support disappears. Look for this form of price support in the IPO registration documents of a company.
- IPO securities are seen as speculative. Investors should carefully study the prospectus:
The prospectus is needed documentation filed by the company planning the IPO and is typically made available to the public a few weeks before the offering. It is intended to provide information to investors that can aid them in determining if the offering is a good investment, such as stock terms, disclosures about the company's financial situation, risk the firm confronts, and specifics about its business plan.
IPOs and SPACs
The special purpose acquisition company (SPAC), also referred to as a "blank check firm," has grown in popularity in recent years. A SPAC obtains capital through an IPO exclusively for the purpose of acquiring other businesses.
Numerous well-known Wall Street investors use their solid reputations to create SPACs, raise capital, and acquire businesses. However, investors in SPACs aren't typically made aware of the companies the business with the blank check plans to acquire. Some companies make clear that they intend to target specific types of businesses, while others completely keep their investors in the dark.
According to George Gagliardi, a CFP in Lexington, Massachusetts, "it's sending your money to an entity that doesn't own anything but assures you, "Trust me, I'll only make excellent acquisitions with it." "You don't know what's coming at you," someone said, "like a baseball batter wearing a blindfold."
Many private businesses decide to be bought out by SPACs in order to hasten the process of going public. SPACs don't have extensive financial histories to declare to the SEC because they are recently founded businesses. If a SPAC does not purchase a firm within 24 months, many SPAC investors will be able to get their money back in full.
According to Goldman Sachs, SPAC IPOs made up more than half of all IPOs in the United States in 2020. The first three weeks of 2021 saw the IPOs of 56 U.S. SPACs.
Key IPO Terms
Initial public offerings have their own specific terminology, much like everything else in the financial industry. You should be familiar with the following major IPO terms:
- Common shares. ownership stakes in a public corporation that normally grants investors the right to vote and receive dividends from the company. A business sells shares of common stock when it goes public.
- Issue cost. The cost of common stock that will be sold to investors prior to an IPO business starting to trade on public exchanges. commonly known as the asking price.
- Lot size. The least amount of shares that can be purchased in an IPO. You must bid in multiples of the lot size if you want to buy more shares.
- Preliminary prospectus. A report produced by the firm doing the initial public offering that contains details about its operations, strategy, historical financial statements, most recent financial performance, and management. It is occasionally referred to as the "red herring" and has red text running down the left side of the front cover.
- Price band. The range of prices that the company and the underwriter will accept bids from investors for IPO shares. Generally speaking, it varies depending on the type of investment. For instance, regular investors like you can be in a different price range than qualified institutional buyers.
- Underwriter. the investment bank in charge of overseeing the offering on behalf of the issuer. In general, the underwriter chooses the issue price, promotes the IPO, and allots shares to investors.
FAQ
How long after buying IPO shares can you sell them?
The shares you acquired through IPO Access are always available for sale. However, it's considered "flipping" and you can be banned from IPO Access for 60 days if you sell IPO shares within 30 days of the IPO.
Who decides the IPO price?
Many investors that take part in IPOs are unaware of the method used to estimate a company's worth. An investment bank is hired to ascertain the value of the company and its shares prior to the public issuance of the stock before they are listed on an exchange.
How is IPO valuation calculated?
To determine how much public capital the company is raising, multiply the number of primary shares sold by the offering price (minus any IPO fees, which vary but can be estimated at 7% of offering profits). Add up the net cash that is already present on the balance sheet of the business (cash-debt).
How do you know if an IPO is overpriced?
These ratios can be calculated by dividing the stock price by the company's revenue per share and net income per share, respectively. The income statement for the company includes both of these numbers. The stock may be expensive if these ratios are higher than those of the company's rivals. An IPO like that should be avoided.
How do banks make money from IPO?
In order to fund the IPO and "purchase" the company's shares before they are really listed on the stock market, a bank or group of banks contributed the necessary funds. The difference in price between what the banks paid before the IPO and when the shares are formally offered to the public is how the banks make their profit.