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Understanding the IPO Process

A n initial public offering, or IPO, occurs when a private company goes public and begins offering stock to public investors to raise capital for growth and expansion. Companies planning an IPO often provide public shares at a premium to existing private investors. All new IPOs must meet the requirements of the federal Securities and Exchange Commission and the relevant stock exchanges.

What Is the IPO Process?

The IPO process marks a company’s transition from a private firm supported by a limited number of investors to one that profits from and serves public shareholders. Before taking this step, the company’s executives must ensure that they can meet all SEC regulations and shareholder requirements. Usually, companies initiate the IPO process when they reach ‘unicorn status,’ or valuation of at least $1 billion as a private company. However, some smaller companies that can adhere to SEC rules can qualify for an IPO with limited market competition.

The company planning an IPO must go through an underwriting due diligence process to reach a share price. The executives must make a public statement or solicit private bids from underwriters, typically investment banks, then choose a professional to conduct this process for the firm’s IPO. Some companies may even work with more than one underwriter in a collaborative process.

During the selection process, each underwriter provides information about his or her experience, services, and pricing. They estimate the IPO time frame, share price, share amount, and type of stock to offer. Some of the factors to consider when hiring an underwriter for an IPO include:

  • Their level of expertise in your business niche.
  • The research quality provided.
  • Their industry reputation.
  • Their reach with individual and institutional investors.
  • Whether you have an existing relationship with the bank they represent.

After selecting an underwriter, the company enters a formal underwriting agreement and assembles its IPO team, which should include:

  • Underwriters.
  • Attorneys.
  • SEC experts.
  • Certified public accountants.

The company must also select the underwriting agreement for its IPO. Common arrangements include the following:

  • All or none agreement, in which the underwriting company cancels the IPO if it cannot sell all the shares.
  • The best efforts agreement, in which the underwriting firm sells shares on behalf of the newly public company but makes no guarantee about profits that will result.
  • The firm commitment agreement, in which the underwriting firm buys the entire IPO for a guaranteed price, then resells those shares on the public market.
  • The syndicate agreement, in which multiple managers from different investment banks each sell a portion of the available shares.

The underwriter must draft an engagement letter, which often includes a reimbursement clause. This type of clause requires the company issuing the IPO to cover underwriter expenses if they cancel the offering at any stage for any reason.

This letter should also include the underwriting discount, also called the gross spread. The company can calculate this number by subtracting the price the underwriter paid for the shares from the price at which the underwriter sold the shares. A common gross spread is 7%, which serves as the underwriter fee.

In a syndicate arrangement, the company appoints a lead firm that typically receives 20% of the gross spread. The other underwriting firms involved split 60% of the spread proportionally based on the number of issues they sell. The other 20% goes to expenses incurred by each underwriting firm.

The underwriter also drafts a letter of intent, which expresses the investment bank’s commitment to underwrite the company’s IPO. It also expresses the intent of the company issuing the IPO to cooperate in due diligence and provide all required documents to the underwriting firm. Typically, a letter of intent establishes an overallotment agreement of 15%.

Once all parties agree on a letter of intent, they move to execute an underwriting agreement. When this document takes effect, the underwriting firm is legally bound to the agreed-upon stock purchase or sale.

Next, the underwriting team works together to prepare the registration statement required by the SEC. This document includes details about:

  • The planned IPO and proposed ticker symbol.
  • The executive team.
  • The company’s comprehensive financials.
  • The company’s legal history.
  • Insider holdings.

The registration statement comes in two separate sections. The private filings are only for SEC internal review, while the prospectus goes to anyone who buys into the IPO.

The underwriter drafts the initial prospectus then uses it as a marketing tool for the upcoming issue. This phase, which lasts three or four weeks, allows them to gauge demand for the shares, which subsequently influences pricing.

In the meantime, the SEC must approve the registration documents for the IPO. When this occurs, the underwriting team can decide the issue date, also called the effective date. The team does not decide the price until the day before the effective date. Factors that influence the share price include:

  • The interest showed by institutional and public investors in the marketing phase.
  • The current state of the economy in the company’s niche.
  • The company’s reasons for issuing the IPO.

What Are the Benefits of an IPO?

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With an IPO, a company can raise more money than it could possibly access from private investors, which in turn accelerates the firm’s growth potential. Because an IPO requires full public disclosure and financial transparency, going public can also make it easier for a company to borrow capital at a favorable interest rate. Following the IPO, a public firm can court more investors in the future by releasing a secondary stock offering.

As a public firm, a company may find it easier to attract skilled employees and managers. It can offer perks such as liquid equity stock participation that appeal to highly qualified candidates. An IPO is also associated with a higher level of prestige and increased exposure, both of which can boost profits and sales.

What Are the Potential Disadvantages of Issuing an IPO?

Some companies that reach unicorn status may nevertheless decide against issuing an IPO. Some of the reasons firms decide to stay private include:

  • The increased expense associated with issuing an IPO and maintaining a public company, which includes marketing, legal, and accounting cost increases.
  • The requirement to disclose business, tax, accounting, and financial information that the owners and executives may prefer to keep private.
  • The attention, effort, time, and cost of meeting SEC and exchange reporting requirements.
  • The loss of private shareholder control as new shareholders begin to obtain voting rights and a board of directors takes power.
  • The risk of the market rejecting the public share price, which will result in the failure of the IPO.
  • The risk of costly regulatory and legal issues, such as shareholder lawsuits.
  • The distraction of fluctuating share prices and their influence on the company’s results.
  • Potential share inflation, which can cause the firm to become unstable.

How Do Executives and Financial Experts Evaluate the Performance of an IPO?

While many IPOs succeed in creating short-term gains for the company, others result in losses. These are some of the factors that contribute to the perception of IPO performance:

  • The lock-up period, during which the company prohibits executives and employees from selling their shares. Often, the company’s stock declines in price dramatically a few months after the IPO date when this period expires and these individuals try to profit off their shares simultaneously. The length of a lock-out must be at least 90 days, according to the SEC, but can last as long as 24 months.
  • Waiting periods, in which the company saves a percentage of shares for later purchase. When these set-aside shares sell, the stock price increases. If they don’t sell, the stock price decreases.
  • Flipping, when an investor purchases stock from an IPO within hours of issue. This often causes the stock price to rise dramatically on the first day of release.
  • Tracking stocks, which means the firm creates a standalone entity that may be worth less or more than the primary company. Some companies use this strategy to keep part of the company private and issue an IPO for the rest.

While many IPOs experience volatility in the days and weeks after release, these ups and downs tend to smooth out over time. When that occurs, investors can use moving averages and other metrics to track the performance of the IPO.

When Did IPOs Originate?

Most historians think the first IPO occurred in 1602 when the Dutch East India Company placed its shares for sale to the public. Since then, the use of IPOs in the business and investment world has fluctuated in popularity. For example, the dot-com boom of the early 2000s brought an unprecedented influx of tech company IPOs, while the 2008 financial crisis led to a limit in new IPOs for several years.

Understanding the ins and outs of IPOs can help investors make smart decisions when it comes to buying shares of large public companies.