Commencing, staging, and finalizing IPOs can be a cumbersome process. It is always time-consuming and quite expensive. Additionally, it can be terminal; lasting six months, or protracted; lasting two years.
A company interested in going public must apply to the Securities and Exchange Commission (SEC). The application is to be allowed to sell stock in the public share market. Planning is essential to carry out a successful IPO. More importantly, IPOs generally involve investment banks, referred to as underwriters.
Companies (the issuer) make their shares available to the underwriters for onward marketing and sale to prospective buyers. The underwriter then approaches the investors with offers to sell those shares. An exceptionally large IPO is underwritten by several banks, referred to as a syndicate. The largest of those underwriters are known as the Lead Underwriter or the Bookrunner.
Upon sales of shares, the members of the syndicate are entitled to a portion of the proceeds. Such fees collected are called an underwriting spread. In practice, the Lead Underwriter takes the largest portion of the underwriting spread, being the underwriter who sells the most.
In IPOs of a multinational nature, multiple syndicates are retained to handle underwriting responsibilities. Issuers allow underwriters in some circumstances to change the size of the offering upwards to a tune of 15% in a process known as the greenshoe option.
This happens when your shares are a “hot issue” or oversubscribed. Clients can be offered a prospectus, detailing all material information concerning the offer. In some cases, it could be a red herring prospectus.
A red herring prospectus always carries a bold warning that the information on the prospectus is incomplete. As such, it is amenable to change. Finally, the issuer needs to retain the services of a printer to print and file the final prospectus with the Securities and Exchange Commission.
At this point, inputs from the issuer, the issuer’s counsel, the underwriter’s counsel, the bookrunner, the issuer’s accountants, and auditors make the final and necessary changes to the prospectus before filing the same with the Securities and Exchange Commission.
The bookrunners set the price for the Initially Offered shares, although alternatives like book building will suffice. Book building involves fixing the price of shares through analysis of confidential investor data concerning demand.
Why Do Companies Offer IPOs?
Companies offer IPOs for the following reasons:
- To raise financial capital, they expand their scope of doing business and bring in benefits and profits on a larger scale.
- It aids such companies to close acquisition deals and evaluate, and consider and value targets for acquisition.
- Easier access to credit and financing through transparent accounting and timely quarterly reporting.
- The status of a public company conferred on the business by the IPO enables it to attract and retain top-shelf management and staff.
- Through liquid stock equity participation, companies can compensate by paying their staff and executives.
What Is the Purpose of an IPO?
An IPO exists to aid a company secure adequate financing to expand business borders. Also, it enhances the credibility and standing of such companies. They position themselves for credit financing and other benefits available to public companies.
Can Anybody Invest in an IPO?
Institutions can invest in an IPO and in turn sell to the general public. However, that greatly depends on your broker. Most brokerage firms may not make the shares available to you. However, most IPO shares are made available to high net worth investors.
How To Participate in an IPO
Prospective Investors ask “what is IPO” and how that can participate in an IPO. Here are some tips to effectively participate, and invest in an IPO:
- Work hand in hand with your brokerage firms, especially ones online. This is for the reason that many of them have already cut deals with underwriters to get a hold of IPO shares.
- If possible, work on, and build a relationship with an underwriter. In case you forgot, underwriters are also investment banks. Within investment banks, IPO shares are oversubscribed and then underwrote for who gets what amount of shares. In such cases, a good relationship with these underwriters can work to your advantage.
- Do not rush, this works out fine in some cases. Upon going public in mid-2012, Facebook shares took a nosedive, and investors who purchased those shares did so at a rate lesser than others who bought previously. Sometimes, waiting can do the magic for you.
Benefits & Disadvantages
In purchasing and participation in IPOs, there are certainly pros and cons you will notice. Here are some of the benefits and disadvantages of IPOs:
Benefits of IPOs
- It helps companies secure funding to build or expand business.
- It increases a company’s viability as a business worthy of investor’s money. That way investors will have no doubts as to whether to invest or not. No investor parts with money in respect of a private company.
- Company Eligibility for large-scale loans is enhanced. In scenarios such as this, public companies can take out loans on a large scale to widen business frontiers or maximize production capacity to gain market share.
- It gives the company visibility, as foreign companies looking to do territorial business can rely on the company due to its standing as a credible public company.
Disadvantages of IPOs
- IPOs can be time-consuming. In the process of staging an IPO, most companies take their foot off the throttle. The day-to-day running of the business suffers as the company is focused on going public.
- In the process of divulging information, they could let in competitors on company secrets. For example in financial, accounting, tax, and sundry businesses, operational information could empower competitors while leading to a loss in market share and competitive advantage.
- There will be a loss of control due to the agency position in which the company now operates. As such, decisions are made by shareholders through the instrumentality of the Board of Directors.
- There is an increase in operational risk, as legal and regulatory issues may arise, bringing with them dire consequences.
How Can I Learn About the Company?
It is the mark of a wise investor to attempt to know more about the company they are desirous of investing in. This is because once they arm themself with the proper bits of information, they can make educated decisions. In conclusion, consulting your brokerage firms and availing yourself of the company prospectus can help you get started.
A Prospectus is a document detailing all necessary information about the company and the shares being offered. A Prospectus comprises the following elements:
- A summary of the company’s background and financial information
- The name of the company issuing the stock
- The number of shares on offer
- The nature of securities being offered
- Names of the principal officers of the company.
- Names of the underwriter(s) or syndicate.
Companies are allowed to make available a red herring prospectus. however, it must be endorsed on the face of the prospectus that it is incomplete and subject to further change.
To make an informed decision and prepare for any eventuality in an IPO, an investor must be aware of risk factors involved in this process, viz:
- There is the risk of not even getting the shares at all. In situations where the IPO shares are in high demand i.e. oversubscribed, the issuer and the underwriters distribute the shares on a proportional basis. Due to that, many investors may not get shares. If you’re a small-time investor, chances are high that you may get nothing out of the process.
- Your liquidity will reduce significantly. Upon purchase of IPO shares, your money remains with the company until the share prices are determined and listed. Therefore, that in itself can take an awful lot of time, so if you’re a small-time investor you’re in for a rough ride.
- In cases where the share price is determined and listed to be lesser than the purchase price, there is a loss. You will get the value for less than the price at which you purchased such shares.
Use of Proceeds
The money earned by the issuer from the investing public in an IPO can be a primary offering or a secondary offering. Essentially, the primary offering goes straight to the company’s coffers, while the secondary offering goes to early investors who choose to sell all or a percentage of their holdings.
There are different approaches to the idea of dividends in an IPO. An issuer may choose from any of the following three Dividend Policies:
- Where investors are not concerned about the payout, then the company will adopt the Dividend Irrelevance policy.
- When investors prefer a high payout, the company shall adopt the bird-in-hand approach.
- Where investors prefer a low payout to facilitate growth, the company adopts the Tax Preference approach.
Dilution is the downward review of the equity standing of the shareholders to accommodate the creation and issuance of new shares. Also, this happens when a company successfully secures additional equity capital. It always puts recent shareholders in a position of advantage over prior or existing shareholders.
Selected Financial Data
Selected Financial Data provides information about a company dating back five years. It contains the company’s audited financial statements like the income statement, balance sheet, and cash flow statements.
Upon attainment of public company status, companies are required to file a 10-K report annually.
Management’s Discussion Analysis
The Management’s Discussion Analysis or an MD&A is a report that enables investors to see the IPO and the company through the eyes of the management. It is an opportunity to gloss over the performance of the company in the past fiscal years and for the future. Lastly, all of this must be done from the perspective of the management.
Ordinarily, businesses suffer in the process of staging an IPO. The business of an IPO is important but attention must also be paid to the day-to-day running of the nominal business.
The idea behind an IPO is to scale up in management. To favorably compete, the company in question must be willing to attract and retain the best hands in management.
Financial Statements & Notes
All financial statements and notes serve to inform investors of the company’s position in the recent past. In practice, it should date back five years.
Factors to Consider
There are certain factors you must consider when looking into IPOs. Here are some of the most important ones.
Offering Price is the price of a share fixed by the Underwriter in the IPO process. The offering price is influenced by the price band and the minimum bid lot. That is decided by the promoters in league with the Lead Underwriter.
Emerging Growth Companies
An emerging growth company is a company that has not completed its first five fiscal years after completion of an IPO. In situations where the company grosses upwards of $1.07 billion annually or issued more than $1billion in non-convertible debt, it ceases to be an emerging growth company.
Stage of the Company
A company normally goes through a three-stage evolution in an IPO process.
- Pre-IPO transformation phase: Firstly, in this phase, the purchase of shares is a bit volatile. This is because the purchase price might differ from the determined and listed price. This may be good or bad. However, this is a high-risk stage to buy IPO shares.
- IPO transaction phase: In this phase, the purchase of IPO shares is advised, as chances of disparity between the purchase price and the listed price are low.
- Post-IPO transaction phase: Lastly, any transaction at this stage is dependent on the ebb and flow of the market.
Dual-Class Common Stock
This is the stratification of the kinds of stock on offer at an IPO. One class of shares confers limited voting power on the shareholder, while the other, reserved for company executives and founders, gives them more voting power.
Market Overhang is a process where investors are hesitant to purchase shares because it has consistently nosedived and will continue to sustain such a downward trajectory.
Limited Trading Volume
In a situation where one-fifth of the aggregated trading volume by the dollar of the Common Stock on Principal Market over a consecutive trading period of twenty (20) trading days instantly before the date of the notice of interest that applies, such one fifth trading volume is the limited trading volume.
These are existing shareholders who are willing to sell their shares in an IPO, where their shares are registered and are part of the offering.
What Affects the Performance of IPOs
Several factors affect the performance of IPOs. Let’s review some of the biggest influencing factors.
A Lock-Up period is a contract provision period preventing insiders from selling or disposing of their shares until after a certain amount of time after the IPO.
The waiting period is the amount of time it takes a company to go public. It can be as short as six months and be as long as two years.
This happens when an investor resells shares or stocks in the first few weeks after an IPO. Flipping is mostly done at a higher price after the shares begin open trading.
A tracking stock is a share issued by the parent holding company which tracks the performance of the division of the holding company. Also, they usually trade in the open market, separate from the stocks of the parent holding company.
Are IPO Shares Good Investments?
The jury is still out on the viability of the IPO shares. It largely depends on the motive of such investors. Where the investor is looking for a quick buck, flipping IPO shares is advisable.
On the flip side, small-time investors do not have a good chance to obtain shares and maximize profit. In a case where such small-time investors purchase their shares in the Pre-IPO transformation stage of a company, the loss is sure.
Alternatives to IPOs
In a situation where an Initial Public Offer is not a viable option, there are lots of ways by which someone can get needed funding. We shall look briefly at these options:
Direct Listing involves the sale of shares by the employees and investors to the public. This helps companies cut out intermediaries and save costs. Take, for example, a company’s employees may choose to sell their shares to ensure that costs to the company are avoided.
Lastly, dutch auction involves the diversification of class shares. This is because everyone is required to pay the same amount per share. It allows shares to be allocated based on price aggressiveness.
William Vickrey’s design for the OpenIPO Dutch auction ranked bids in order. It showed the highest bids and eliminated the low ones, with the highest bidders paying the same price per share.
IPOs are a very exciting but, tasking time for every company. Its protracted nature is a daunting test for every company. In conclusion, investors are advised to consult with their brokerage firms and financial advisors to make the most out of this process.