What Is the IPO Process?
A n IPO is the process that a privately owned corporation takes to issue its stock to the public. An IPO often gives a company a large financial boost, which it can use to promote organizational growth. Buying shares as soon as a company holds an IPO is a great way to get in on the ground floor, but it can also pose a few risks. Getting to know the IPO process can help you decide when you want to invest in a new public company.
- To hold an IPO, the company must meet varying requirements by individual exchanges and the Securities and Exchange Commission.
- IPOs are excellent opportunities for private companies to gain more capital for growth and expansion.
- Companies almost always use underwriters to make the process go smoothly.
- An IPO is a way for the early investors and founders to maximize profits from their initial investment as an exit strategy.
How Does an IPO Work?
Corporations are privately owned by a number of investors, like venture capitalists, angel investors, company founders, and the founders’ circle of family and friends, prior to the IPO. As a private company grows, it may reach a point where it needs capital to continue its growth. If the company’s at a maturity point that can handle the requirements set by the SEC and can fulfill all duties to the shareholders, it can begin to publicize their intent of launching an IPO.
Commonly, when a company reaches a value of about $1 billion (aka unicorn status), they’re at an excellent stage to consider an IPO.
The time to offer an IPO is not a hard and fast rule. Various factors make a company qualified for an IPO at different valuations depending on the current market and requirements.
An IPO is a major step for any company providing capital for expansion. The transparency inherent in going public can also help improve any loans the company may need to take on in the future.
The underwriting done by the investment bank hired to help the company with an IPO will determine the initial pricing on an IPO. After going public, any shares owned by the private shareholders becomes publicly traded shares valued at the determined IPO value. The underwriting can also provide any additional amenities or benefits for the private investors as the company goes public.
Underwriting the IPO
Underwriting is the process in which an investment bank acts as a broker between the company and public investors. There are a few different types of underwriting agreements that the investment bank may offer. First is the firm commitment agreement in which the underwriting investment bank purchases the entire initial offering and then resells the shares to the public. This method allows a guarantee that a certain amount of money will be raised, thus trading greater potential for less risk.
Another agreement is the best efforts agreement, which stipulates that the underwriter offers no guarantees on the amount that will be raised but instead is just selling the shares for the company. They may include an optional all-or-none-agreement where either all shares must be sold or the entire offering is canceled.
Finally, if there are multiple underwriters, one is chosen to be the lead manager. In this scenario, a syndicate of underwriters forms, and each underwriter sells a portion of the IPO.
Here’s a very basic overview of the process of an IPO:
1. The company solicits and evaluates the various proposals presented by underwriters
These proposals consist of what their services entail, the best security to issue, the potential offering price, the number of shares to release, and an approximate time frame for the market offering. After the evaluation period, the company chooses its underwriter(s) and officially enters into a contractual relationship.
2. The Company Forms Teams of Underwriters, Lawyers, CPAs, and SEC Experts
The IPO team gathers the required information for the requisite IPO documentation. The main IPO document is the S-1 Registration Statement. This consists of the privately held filing information as well as the prospectus. Both parts of the S-1 are living documents that are consistently updated and revised throughout the process. Also included in the S-1 is the preliminary data of the upcoming filing.
The team also needs to create marketing materials. Underwriters, with the assistance of the executives, analyze the market to approximate demand and determine an offering price. As this process continues, they update this information.
3. The Company Creates a Board of Directors
The board will create and verify procedures for the reporting of auditable financial statements and accounting information every quarter.
4. The Company Goes Public
The team Issues shares on the official IPO date. Capital from the sales is received as cash by the company and reported as stockholder’s equity. Post-IPO provisions also occur, such as underwriters having an extended period to buy more shares after the initial IPO.
Financial Advantages of an IPO for the Corporation
Image via Flickr by Damian Gadal
The primary purpose of the IPO is to generate capital, but there are other advantages an IPO presents.
- Companies have access to the entire public investment market.
- It’s easier to determine the value of an acquisition target.
- Increased transparency and quarterly reporting can lead to better rates on borrowed funds.
- Secondary offerings after the initial IPO can generate further capital.
- It gives the company the ability to offer stock options to prospective employees to attract and keep better management and high-end employees.
- IPOs offer increased exposure, prestige, and public image, generating more sales and more profits.
Disadvantages of an IPO
As lucrative as an IPO can be, there are potential downsides as well.
- The process is costly, and there are costs beyond the typical price of doing business when the company is publicly traded.
- A publicly traded company must disclose financial, tax, accounting, and any other business information.
- The requisite reporting requires additional effort and staff hours to prepare, which is an additional cost to the company.
- Potential funding not being generated if the IPO price was not accepted by the market and shares were not purchased.
- There is a potential loss of control to the new shareholders who have acquired voting rights.
- There could be an increased risk via private securities class action lawsuits and actions of the shareholders.
- Stock value fluctuations can be a distraction and lead companies to change direction, perhaps prematurely.
- Specific methods used to increase the value of the shares, i.e., using excessive debt for stock buybacks, can lead to instability of the company.
- A board of directors that is overbearing can lead to difficulties in acquiring and retaining forward-thinking executives.
There is a great deal of inherent expense, risks, and effort associated with becoming a publicly traded company. This risk may be more than a company is willing to take, so it can continue to remain private. Companies can also seek buyouts as an alternative.
Alternatives to the Traditional IPO
The traditional IPO is the most common way for companies to go public. However, some companies might try the following:
A direct listing occurs when an IPO happens without assistance from underwriters. This method increases the risk of failure but can also lead to a higher initial price. This method is only relevant for a company that is already well known with an attractive and established brand.
Another alternative to a traditional IPO is a Dutch auction, which is when the IPO price has not been set ahead of time. Instead, potential investors bid based on what they’re willing to pay and the number of shares they want. Those who bid the highest price are awarded the available shares. Alphabet (parent company of Google) used this type in 2004 for its initial public offering.
A n IPO can be an excellent way for a private company to grow and inject capital into its business, but it is not without risk. If you’re looking into buying shares during an IPO, carefully research the company and the steps they took to go public to make sure you’re getting the best value for your investment.