Understanding the Initial Public Offering (IPO) Process

An initial public offering (IPO) is a private company’s first sale of shares of stock to the public. In essence, an IPO means that a company's ownership is transitioning from private ownership to public ownership. Startup companies or companies that have been in business for decades can decide to go public through an IPO.

The process allows a company to raise capital while also capturing the attention of the media and potential customers. In an IPO, after a company decides to "go public," it chooses a lead underwriter to help with the securities registration process and distribution of the shares to the public. When a company becomes publicly listed, the money paid by the investing public for the newly issued shares goes directly to the company (primary offering) as well as to any early private investors who opt to sell all or a portion of their holdings (secondary offerings) as part of the larger IPO. An IPO, therefore, allows a company to tap into a wide pool of potential investors to provide itself with capital for future growth, repayment of the debt, or working capital.

After the IPO, shares are traded freely in the open market at what is known as the free float. Stock exchanges stipulate a minimum free float both in absolute terms (the total value as determined by the share price multiplied by the number of shares sold to the public) and as a proportion of the total share capital (i.e., the number of shares sold to the public divided by the total shares outstanding).

The earliest form of a company which issued public shares was the case of the publicani during the Roman Republic, although this claim is not shared by all modern scholars. Like modern joint-stock companies, the publicani were legal bodies independent of their members whose ownership was divided into shares, or parts. There is evidence that these shares were sold to public investors and traded in a type of over-the-counter market in the Forum, near the Temple of Castor and Pollux. The shares fluctuated in value, encouraging the activity of speculators, or quaestors.

Purchasing stock during an IPO can be financially risky, as stock prices for newly public companies tend to be influenced by media attention and can fluctuate significantly. However, many investors consider the benefits to outweigh the risks.

An investment in an IPO has the potential to deliver attractive returns. If you are considering investing in an IPO, it is also important to avoid getting swept up in the hype that can surround a promising young company. Investors became acutely aware of these risks while investing in IPOs during the technology stock boom and bust of the late 1990s and early 2000s. Before investing, be sure to do your own due diligence. This task can be challenging because of the lack of readily available public information on a company that is issuing stock for the first time.

When you participate in an IPO, you agree to purchase shares of the stock at the offering price before it begins trading on the secondary market. Before you can invest in an IPO, you first need to determine if your brokerage firm offers access to new issue equity offerings and, if so, what the eligibility requirements are. Typically, higher-net-worth investors or experienced traders who understand the risks of participating in an IPO are eligible. Individual investors may have difficulty obtaining shares in an IPO because demand often exceeds the amount of shares available. Assuming you have done your research and have been allocated shares in an IPO, it is important to understand that while you are free to sell shares obtained through an IPO whenever you deem appropriate, many firms will restrict your eligibility to participate in future offerings if you sell within the first several days of trading. It's also important to remember that there is no guarantee that a stock will continue to trade at or above its initial offering price once it starts trading on a public stock exchange. Investing in a newly public company can be financially rewarding; however, there are many risks, and profits are not guaranteed.

Public offerings are sold to both institutional investors and retail clients of the underwriters. A licensed securities salesperson (Registered Representative in the US and Canada) selling shares of a public offering to his clients is paid a portion of the selling concession (the fee paid by the issuer to the underwriter) rather than by his client.

Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus.

Key Steps in the IPO Process

Businesses based in the United States must complete a number of steps prior to holding an IPO. A company must first ensure that it is properly structured and that all business activities have been carried out and documented in accordance with all applicable regulations, as public companies face an increased amount of scrutiny from both regulatory bodies and shareholders.

Most companies undertake an IPO with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide several services, including help with correctly assessing the value of shares (share price) and establishing a public market for shares (initial sale).

Next, the company must collaborate with securities underwriters, or investment banks that oversee the marketing and sale of the shares, to determine the price at which the shares will be offered. In some cases, a uniform share price is set through a “Dutch auction,” in which potential investors place bids and only those who bid high enough receive shares; however, this practice is relatively uncommon. A Dutch auction allows shares of an initial public offering to be allocated based only on price aggressiveness, with all successful bidders paying the same price per share.

One version of the Dutch auction is OpenIPO, which is based on an auction system designed by economist William Vickrey. This auction method ranks bids from highest to lowest, then accepts the highest bids that allow all shares to be sold, with all winning bidders paying the same price. It is similar to the model used to auction Treasury bills, notes, and bonds since the 1990s.

The company must then assemble a prospectus that includes a summary of the company’s history, risk factors, and other financial and organizational information that potential investors should know.

Next, the company must file a registration statement, consisting of the prospectus and additional documentation, with the Securities and Exchange Commission (SEC). The SEC will review the statement to ensure that it makes all the necessary disclosures and may request that the company make changes or supply further information. The company must also receive approval from the Financial Industry Regulatory Authority (FINRA), a private corporation that oversees the underwriting process, and from the market on which the company will be listed, such as the New York Stock Exchange (NYSE) or the NASDAQ.

The final step in preparing and filing the final IPO prospectus is for the issuer to retain one of the major financial "printers", who print (and today, also electronically file with the SEC) the registration statement on Form S-1.

Following the filing of the registration statement, representatives of the company will embark on what is known as the “road show,” a series of meetings with prospective investors. After the SEC declares the registration statement effective, the company will make the final arrangements with the underwriters, who will then begin the IPO and complete sales of stock. The IPO will typically close within three or four business days, depending on the time of day at which it opened.

In addition to managing the IPO itself, the underwriters determine which investors are eligible to purchase shares of stock during the first public offering. Underwriters typically work with institutional investors, such as hedge funds, as well as a select pool of experienced individual investors. Buying shares of stock with the intention of immediately reselling them-a process known as “flipping”-is discouraged, and investors with a history of doing so may be banned from participating in IPOs.

The Role of Underwriters

Planning is crucial to a successful IPO. IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters into a contract with a lead underwriter to sell its shares to the public. A large IPO is usually underwritten by a "syndicate" of investment banks, the largest of which take the position of "lead underwriter". Upon selling the shares, the underwriters retain a portion of the proceeds as their fee. This fee is called an underwriting spread.

The spread is calculated as a discount from the price of the shares sold (called the gross spread). Components of an underwriting spread in an initial public offering (IPO) typically include the following (on a per-share basis): manager's fee, underwriting fee-earned by members of the syndicate, and the concession-earned by the broker-dealer selling the shares. The manager would be entitled to the entire underwriting spread. A member of the syndicate is entitled to the underwriting fee and the concession.

Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the major selling syndicate in its domestic market, Europe, in addition to separate group corporations or selling them for US/Canada and Asia.

The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under a specific circumstance known as the greenshoe or overallotment option.

Pricing the IPO

A company planning an IPO typically appoints a lead manager, known as a bookrunner, to help it arrive at an appropriate price at which the shares should be offered. There are two primary ways in which the price of an IPO can be determined. Historically, many IPOs have been underpriced. The effect of underpricing an IPO is to generate additional interest in the stock and a rapid rise in share price when it first becomes publicly traded (known as an "IPO pop"). Flipping, or quickly selling shares for a profit, can lead to significant gains for investors who were allocated shares of the IPO at the offering price.

However, underpricing an IPO results in lost potential capital for the issuer. One extreme example is theglobe.com IPO which helped fuel the IPO "mania" of the late 1990s internet era. Underwritten by Bear Stearns on 13 November 1998, the IPO was priced at $9 per share. The share price quickly increased 1,000% on the opening day of trading, to a high of $97. Selling pressure from institutional flipping eventually drove the stock back down, and it closed the day at $63.

The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, the stock may fall in value on the first day of trading. If so, the stock may lose its marketability and hence even more of its value. This could result in losses for investors, many of whom being the most favored clients of the underwriters.

Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock but high enough to raise an adequate amount of capital for the company. Some researchers (Friesen & Swift, 2009) believe that the underpricing of IPOs is less a deliberate act on the part of issuers and/or underwriters, and more the result of an over-reaction on the part of investors (Friesen & Swift, 2009). One potential method for determining to underprice is through the use of IPO underpricing algorithms.

Quiet Periods

Under American securities law, there are two-time windows commonly referred to as "quiet periods" during an IPO's history. The first is the period of time following the filing of the company's S-1 but before SEC staff declare the registration statement effective. The other "quiet period" refers to a period of 10 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. When the quiet period is over, generally the underwriters will initiate research coverage on the firm.

Stag Profit

"Stag profit" is a situation in the stock market before and immediately after a company's initial public offering (or any new issue of shares). A "stag" is a party or individual who subscribes to the new issue expecting the price of the stock to rise immediately upon the start of trading. Thus, stag profit is the financial gain accumulated by the party or individual resulting from the value of the shares rising. This term is more popular in the United Kingdom than in the United States.

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