Understanding Initial Public Offerings (IPOs)

When a private company first sells shares of stock to the public, this process is known as an initial public offering (IPO). 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.

An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company.

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 and as a proportion of the total share capital.

Private companies go public for a variety of reasons, from generating capital to consolidating brand presence. An IPO represents an opportunity to raise large amounts of money from new shareholders while (typically) retaining majority ownership.

For many small and medium-size businesses, going public is a major aspiration. The primary reason most companies undertake an IPO is capital. By selling shares of the company to the public for cash, organizations can fund all manner of operations such as mergers and acquisitions, internal research and development, general capital expenditure, and the payoff of existing loans.

For many early investors, a company going public marks the end of their involvement. For serial entrepreneurs looking to fund new ventures, selling IPO shares frees up much-needed finances. An IPO is also an opportunity for a company to develop its brand image and public standing.

The number of shares a company sells and the share price are often considered newsworthy. 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.

An investment in an IPO has the potential to deliver attractive returns. However, 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.

It’s been a quiet two years for initial public offerings (IPOs) and 2024 is shaping up to be no different. High inflation, high interest rates, and economic uncertainty resulted in many companies delaying their debuts. Two years later, the 2024 IPO market remains cautious across the world. As the economy continues to recover, that question will become more and more pertinent.

The IPO Process Explained

Traditionally, the IPO process is initiated by a private company hiring several investment banks-often referred to as “underwriters”-to advise on the transaction and ensure the maximum amount of capital is raised, with the minimal amount of issues encountered.

Step 1. Hire Underwriters

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. Together, the underwriters of the IPO must structure the offering and settle on the terms. In particular, the offering price must be set appropriately, where the maximum amount of capital is raised.

Step 2. Red Herring Prospectus + Roadshows

Once the company prepares to “go public”, the investment banking advisors will market the company to institutional investors via “roadshows” to first secure demand from those investors with substantial sums of capital. The roadshow comprises a series of presentations given by senior management alongside their team of advisors to potential institutional investors to gauge their initial interest and figure out how to convince them to participate, i.e. “book building”.

Before the roadshow, the advisors also prepare a preliminary prospectus, also known as the “red herring prospectus”, which contains information on the company. In the US, clients are given a preliminary prospectus, known as a red herring prospectus, during the initial quiet period. The red herring prospectus is so named because of a bold red warning statement printed on its front cover. The warning states that the offering information is incomplete, and may be changed. Brokers can, however, take indications of interest from their clients.

Step 3. Submit S-1 Filing

The pricing of the offering is arguably the most important decision because the offering price is perhaps the most influential determinant of investor demand. The terms surrounding the IPO, such as the offering price and listing date are largely predicated on the interest level of institutional investors, as their participation is crucial to the underwriting process.

Step 4. Obtain Formal SEC Approval

The formal approval and sign-off on the S-1 filing from the SEC is mandatory before the company’s shares can be distributed into the open markets.

Step 5. IPO Share Issuance

Once shares are officially issued, the company’s IPO is technically complete, and it is now recognized as a publicly traded company. But the underwriters must continue with their efforts to ensure all the stock issuances are sold and to stabilize the price, if necessary.

The SEC S-1 Filing Requirement for IPOs

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

The first part of the S-1 contains the legally required information detailing the sale of the securities. The information covered tends to be an overview of the company’s history, its long-term vision (i.e.

The company’s operating segments must be identified and described in detail. The methodology used to arrive at the stated offering price is explained in-depth here.

Since dilution is a significant risk to investors, the current capitalization (i.e. A biography section with details on the background and qualifications of each director and executive officer.

Benefits of an IPO (“Going Public”)

The benefits of becoming publicly traded, especially from a monetary perspective, are relatively straightforward. By becoming a publicly-traded company, a company can potentially benefit from having access to cheaper forms of capital.

Liquidity Event

From the perspective of management and existing pre-IPO investors, the IPO can be a liquidity event. While the IPO is an opportunity for management to “take some chips off the table”, venture firms and growth equity investors often must liquidate all of their positions, irrespective of their long-term thesis on the company’s prospects.

The pre-IPO company, in all likelihood, is backed by venture investors and growth equity investors, so the IPO is an liquidity event, albeit there are restrictions on the timing of when those shares can be sold (i.e. the lock-up period). Venture capital firms and growth equity firms, at the end of the day, are investing on behalf of their limited partners (LPs), so the positions must be exited after the lock-up period and the sale proceeds are then distributed back to the LPs.

Improved Branding

As a side benefit, the company’s branding tends to benefit substantially post-IPO, especially from investors interested in potentially owning shares, which indirectly expands the company’s name recognition and makes it easier to attract (and retain) more qualified employees.

Lower Cost of Capital

By becoming a publicly-traded company, a company can potentially benefit from having access to cheaper forms of capital.

Risks of an IPO

There are also potential disadvantages of going public-hence the caution in the current marketplace. Once a business becomes publicly traded, it also has to follow different rules and regulations. That means regularly disclosing financial data while also updating shareholders with results on a biannual basis. Going public involves multiple stages and additional parties, including investment bankers, the securities and exchange commission (or local equivalent), and institutional investors. It also exposes a business to much more scrutiny from the public and government agencies.

Less Control

The primary risk to management is the company-by virtue of becoming a public company-is no longer under their complete ownership and control.

Disclosure Requirements

The disclosure requirements as part of going public is meant to provide full transparency of the internal workings of the company, which opens management up to public scrutiny by investors. In addition, the company’s closest competitors can access their filings such as their financials and plans to achieve future growth.

Near-Term Oriented

The quarterly filings (10-Q) place more pressure on the management team to meet short-term earnings targets (i.e. earnings per share) and other performance metrics tied to revenue or EBITDA, for instance. Hence, management’s decisions can become short-term oriented due to the external pressure from shareholders and the market to meet their quarterly or annual earnings guidance and targets set by external parties.

Costly Process

The process of going public can be a lengthy process, where the company incurs significant costs, such as advisory fees paid to the investment banks, legal fees paid to lawyers, and other fees paid to third parties like auditors and consultants.

Operational Disruption

The disruption to the company’s day-to-day operations is yet another factor that must be taken into account. The IPO process can meet unexpected, time-consuming hurdles that can extend the time from announcement to becoming a public company. In that stretch of time, employees can easily become distracted by the media coverage, while management is likely occupied with the entire ordeal of the IPO requirements.

Reporting Requirements

The reporting requirements associated with becoming a public company mean more time, effort, and capital must be spent on ensuring compliance with the strict rules established by the SEC.

IPO vs. Direct Listing

In recent years, more companies have opted to go public through a direct listing, as opposed to via an IPO. There are significant risks attached to the decision to go public via a direct listing, where the upside and downside are both magnified.

For instance, Spotify (NYSE: SPOT) decided to proceed with the direct listing route at a time when the company was already the market leader in the music streaming vertical.

Cost Savings

The shares of newly public companies often surge on the first day of trading, with the market capitalization. With that in mind, the underpricing of an IPO can be attributed to the investment bank’s primary goal of selling all the shares offered in the issuance. The post-IPO spike in the share price of a newly listed company represents profits to the investors.

Therefore, many critics support direct listing instead of the traditional IPO.

Tips for Investors Considering IPOs

• Due Diligence: 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.
• Brokerage Access: 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.
• Selling Restrictions: 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.

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