Understanding the Initial Public Offering (IPO) Process

An initial public offering (IPO) is the process of a company selling its shares to the public for the first time. IPOs are typically used by young companies to raise capital for future business expansion. Through this process, colloquially known as floating or going public, a privately held company is transformed into a public company.

Prior to an IPO, a company is considered to be private - with a smaller number of shareholders, limited to accredited investors (like angel investors/venture capitalists and high net worth individuals) and/or early investors (for instance, the founder, family, and friends). After the IPO, the issuing company becomes a publicly listed company on a recognized stock exchange.

These shares are initially issued in the primary market at an offering price determined by the lead underwriter (this is who organizes the syndicate of banks and brokers). The primary market consists of investment banks and broker dealers that the lead underwriter assembles. These banks and broker dealers allocate shares to institutional and individual investors.

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

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).

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. Mere evidence remains of the prices for which parts were sold, the nature of initial public offerings, or a description of stock market behavior.

IPO procedures are governed by different laws in different countries. Planning is crucial to a successful IPO.

The IPO Process: A Step-by-Step Guide

The IPO Process is essential for a healthy financial market. The Initial Public Offering IPO Process is where a previously unlisted company sells new or existing securities and offers them to the public for the first time.

The IPO is the most commonly recognized new issue and is the process by which a private company becomes a public company and sells its shares to the public for the first time. For IPOs, where there is no actively traded stock, companies will file preliminary prospectus documents on SEDAR (System for Electronic Document Analysis and Retrieval) for public review.

Here's a breakdown of the key steps involved:

1. Hire Underwriters: 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. The first step in the IPO process is for the issuing company to choose an investment bank to advise the company on its IPO and to provide underwriting services.
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. Before the roadshow, the advisors also prepare a preliminary prospectus, also known as the “red herring prospectus”, which contains information on the company (e.g.
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. The primary event in an IPO is when the issuer files a Form S-1, which is the most common registration statement used for IPOs.
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. The SEC requires that the issuing company and its underwriters file a registration statement after the details of the issue have been agreed upon. The registration statement ensures that investors have adequate and reliable information about the securities.
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, i.e.

The Role of Underwriters

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". 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.

Underwriting is the process through which an investment bank (the underwriter) acts as a broker between the issuing company and the investing public to help the issuing company sell its initial set of shares.

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.

There are two primary types of underwriting agreements:

• Firm Commitment: Under such an agreement, the underwriter purchases the whole offer and resells the shares to the investing public. The firm commitment underwriting arrangement guarantees the issuing company that a particular sum of money will be raised.
• Best Efforts Agreement: Under such an agreement, the underwriter does not guarantee the amount that they will raise for the issuing company.

Public offerings can be managed by one underwriter (sole managed) or by multiple managers. When there are multiple managers, one investment bank is selected as the lead or book-running manager. Under such an agreement, the lead investment bank forms a syndicate of underwriters by forming strategic alliances with other banks, each of which then sells a part of the IPO.

Gross spread is arrived at by subtracting the price at which the underwriter purchases the issue from the price at which they sell the issue. Typically, the gross spread is fixed at 7% of the proceeds. The gross spread is used to pay a fee to the underwriter. If there is a syndicate of underwriters, the lead underwriter is paid 20% of the gross spread. 60% of the remaining spread, called “selling concession”, is split between the syndicate underwriters in proportion to the number of issues sold by the underwriter.

The letter of intent remains in effect until the pricing of the securities, after which the Underwriting Agreement is executed.

SEC Regulations and the S-1 Filing

To prevent securities fraud, the Securities Act and SEC Rules regulate the IPO Process. Section 5 and SEC rules strictly regulate when and how the issuer can communicate with and act towards investors prior to SEC review, in what is known as gun-jumping.

Prior to filing a Form S-1, the issuer is in the pre-filing period. During this time, Section 5(c) prohibits the issuer from making any “offer” to sell securities, and Section 2(a)(3) defines “offer” as all communications that may condition the market for the sale of the securities.

Once the issuer files the S-1, they are in the waiting period. During the waiting period, the issuer and underwriter begin to gauge market interest and the SEC reviews the S-1. Section 5 of the Securities Act allows the issuer to make offers to sell their security under certain conditions. Section 5(b)(1) allows oral offers, and companies often conduct roadshows during this time.

The registration statement consists of information regarding the IPO, the financial statements of the company, the background of the management, insider holdings, any legal problems faced by the company, and the ticker symbol to be used by the issuing company once listed on the stock exchange. The SEC requires that the issuing company and its underwriters file a registration statement after the details of the issue have been agreed upon. The registration statement ensures that investors have adequate and reliable information about the securities.

Here's a look at what typically goes into the S-1 filing:

• 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, e.g.
• 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 (e.g.

Pricing and Allocation of Shares

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.

Deciding the offer price is important because it is the price at which the issuing company raises capital for itself. IPOs are often underpriced to ensure that the issue is fully subscribed/ oversubscribed by the public investors, even if it results in the issuing company not receiving the full value of its shares. If an IPO is underpriced, the investors of the IPO expect a rise in the price of the shares on the offer day. It increases the demand for the issue. Furthermore, underpricing compensates investors for the risk that they take by investing in the IPO.

One potential method for determining to underprice is through the use of IPO underpricing algorithms.

The sale (allocation and pricing) of shares in an IPO may take several forms. 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.

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.

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. At the time of the stock launch, after the Registration Statement has become effective, indications of interest can be converted to buy orders, at the discretion of the buyer.

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.

Dutch Auction IPOs

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.

Investment banks have shown resistance to the idea of using an auction process to engage in public securities offerings. The auction method allows for equal access to the allocation of shares and eliminates the favorable treatment accorded important clients by the underwriters in conventional IPOs.

From the viewpoint of the investor, the Dutch auction allows everyone equal access. Moreover, some forms of the Dutch auction allow the underwriter to be more active in coordinating bids and even communicating general auction trends to some bidders during the bidding period.

Quiet Periods and Stag Profit

Under American securities law, there are two-time windows commonly referred to as "quiet periods" during an IPO's history. The first and the one linked above 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" 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.

Benefits of an IPO

Undergoing an IPO (i.e. The benefits of becoming publicly traded, especially from a monetary perspective, are relatively straightforward.

• Liquidity Event: From the perspective of management and existing pre-IPO investors, the IPO can be a liquidity event.
• 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, e.g.

Risks of 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.

• 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.
• Near-Term Oriented: The quarterly filings (10-Q) place more pressure on the management team to meet short-term earnings targets (i.e.
• 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.
• 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.

Direct Public Offering (DPO)

Financial historians Richard Sylla and Robert E. Wright have documented that in the early years of the United States, corporations sold shares in themselves directly to the public without the aid of intermediaries like investment banks. The direct public offering (DPO), as they term it, was not done by auction but rather at a share price set by the issuing corporation. In this sense, it is the same as the fixed price public offers that were the traditional IPO method in most non-US countries in the early 1990s.

After the IPO

After the issue has been brought to the market, the underwriter has to provide analyst recommendations, after-market stabilization, and create a market for the stock issued. The underwriter carries out after-market stabilization in the event of order imbalances by purchasing shares at the offering price or below it.

The final stage of the IPO process, the transition to market competition, starts 25 days after the initial public offering, once the “quiet period” mandated by the SEC ends. During this period, investors transition from relying on the mandated disclosures and prospectus to relying on the market forces for information regarding their shares. After the 25-day period lapses, underwriters can provide estimates regarding the earning and valuation of the issuing company. Thus, the underwriter assumes the roles of advisor and evaluator once the issue has been made.

The IPO is considered to be successful if the company’s market capitalization is equal to or greater than the market capitalization of industry competitors within 30 days of the initial public offering.

The IPO is considered to be successful if the difference between the offering price and the market capitalization of the issuing company 30 days after the IPO is less than 20%.

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