- IPO is the acronym for initial public offering. It is the process by which a private company offers shares of itself to the general public.
- One of the main reasons that a private company would choose to go public is that it is easier to raise capital.
- The private company chooses an investment bank to advise it on its IPO and to provide underwriting services.
IPO is the acronym for initial public offering. It’s when a private company offers shares of itself to the general public to invest in, a process known as “going public.” These newly minted shares can be bought and sold on a stock exchange, like the New York Stock Exchange (NYSE) or Nasdaq, by any investor who wants to.
Both private and public companies are technically owned by their shareholders. The difference is that the shareholders of a private company are its founders and investors while the shareholders of a public company will include the investing public that has bought its shares.
Private companies are not beholden to the investing public or required to file documentation with the Securities and Exchange Commission (SEC). However, they cannot access funding from the investing public either. Rather, they must turn to private sources to procure capital.
Public companies, on the other hand, can raise capital from the investing public by issuing more stocks and/or bonds. But they are subject to scrutiny from the public.
Why do companies go public?
There are a few reasons why a private company would choose to go public. Perhaps the main reason is that it is easier to raise capital. Since the company would be regulated by the SEC, which requires full financial disclosure, the investing public is more willing to buy its shares, thereby providing it with funding.
Going public also increases the liquidity of the company’s stock, which makes it easier for shareholders to buy and sell the stock. A company could potentially benefit employees with stock as part of their pay package as it quantifies the market value of these shares. Finally, an IPO is a form of advertising in that it provides exposure to the company and its line of business.
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How does an IPO work?
There are a few necessary steps before an IPO comes to market. The main ones are:
Selecting an underwriter
The issuing company chooses an investment bank, preferably a reputable one with expertise in its line of business, to advise it on its IPO and to provide underwriting services.
Due diligence
The underwriter is the broker who facilitates the sale of the issuing company’s shares to the investing public. As such, it is imperative that the investment bank thoroughly checks out the company.
Regulatory filings
The underwriter must submit the appropriate regulatory filings with the SEC. These include the engagement letter, which spells out the reimbursement clause and gross spread, registration statement and “red herring” document.
- The reimbursement clause requires that the issuing company cover all out-of-pocket expenses incurred by the underwriter, while the gross spread is the difference between where the underwriter buys the issue and where they sell it. The gross spread is how the underwriter makes its money and is typically around 7% of the total proceeds.
- The registration statement provides all the pertinent information about the IPO, such as the company’s financial statements, legal issues that the company faces and management profiles. There are two parts to this – the prospectus, which is available to the investor, and private filings that are provided to the SEC only.
- The “red herring” document is the preliminary prospectus that provides general information about the company but doesn’t go into the details, such as financial information. Essentially, it is a rough draft that must be approved by the SEC before the actual prospectus is filed.
Pricing
Once the SEC has approved the IPO, the issuing company and the underwriter finalize the initial price of the shares being offered by the issuing company and the exact number of shares that will be available to the investing public.
Marketing the IPO
After the IPO launch, the underwriter must create a market for the issued stock and ensure that any order imbalances are rectified. This process, known as after-market stabilization, gives the underwriter a 25-day window, known as the “quiet period,” to influence the pricing of the stock.
Transition
Once the SEC mandated “quiet period” ends, the IPO is fully exposed to market forces. Basically, investors “transition” from relying on the prospectus to gauge the value of the stock to seeing how it trades on the market.
Buying an IPO
Generally, it is quite difficult for average investors to buy shares in an IPO, especially at the initial price set by the underwriter. These shares tend to be set aside for big institutional investors, like pension funds and large hedge funds. However, a few brokerages, especially if they’re affiliated with big banks, are being allocated a small portion of pre-launch IPO shares. Even then, the investor will likely need to have a sizable amount of assets with that broker to be qualified to participate.
Once an investor meets the requirements, they have to request the number of shares that they would like to buy. This may not be granted in full. The final step is to place the order. Only then can the investor know if they were able to buy any shares, but, if shares were bought, the price will be what the investor wanted to pay.
The investing public has full access to trade the shares of the company after the “quiet period.”
SPACs vs. IPOs
SPAC is the acronym for “special purpose acquisition company” and is often referred to as a “blank check” entity. They have already gone through the IPO process. Their goal is to acquire or merge with promising private companies, which would take that company public without the need for an IPO. This reduces the cost and the time that it would take the private company to go through the IPO process themselves.
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