What is an Initial Public Offering (IPO)?
An initial public offering, or IPO, is the process of a private company becoming listed on a stock exchange and allowing the general public to buy its shares for the first time. This is usually done for a company to obtain capital without having to go into more debt than it would like.
However, an IPO can be a long and lengthy process involving close work with investment banks. The company needs to meet an extensive list of requirements from stock exchanges.
An IPO also needs to be approved by a country’s oversight agencies and regulatory authorities, such as the Securities and Exchange Commission (SEC) in the US.
How Do IPOs Work?
An IPO is a kind of equity financing. This means that, in return for capital, shareholders will have a small part of ownership in the company through the number of shares they buy.
This is as opposed to debt financing, where interest is charged for capital, but no ownership of the company is involved.
Before an IPO, a private company has quite a small number of stakeholders and early investors. These could be the founders, friends and family, and even long-term early employees who may have lent the company some capital.
A company usually waits until it reaches a certain valuation, strong fundamentals, and a robust strategy to plan for an IPO. Companies also wait until they are quite sure that they can meet the government and financial regulatory requirements. These include transparency and handling public shareholders, amongst others.
A number of entities also wait until they achieve “unicorn status” or a valuation of $1 billion before announcing an IPO, but this is not always the case.
As long as a company has strong fundamentals, proven profit-generating capacity, and fulfills the listing requirements, it should usually be eligible for an IPO.
One of the main factors of an IPO is valuing the private company, which can be quite difficult and subjective. This is because there is not much public or historical pricing information to go by. The company works closely with one or several investment banks, known as a syndicate, to assess the company value, IPO price, and date.
Initial public offerings can also be profitable exit strategies for founders and early investors, as it allows them to realize the full potential of their holdings.
However, it can be difficult for individual investors to be part of these offerings, as larger or institutional investors are usually favored.
7 Steps to Launch an IPO
Launching an IPO has several steps, as highlighted below:
- Selecting an Underwriter: At this very initial stage, a number of underwriters, usually investment banks, submit proposals to underwrite the IPO. These contain details of services, offering price, type of security to issue, and number of shares. These also include how long the entire market offering process is likely to take. Once the company has reviewed all the proposals, it chooses an underwriter or a group of them. Industry experience, IPO track record, and reputation of the bank all influence this decision.
- Creating a Team: Once the company chooses the underwriter, it also needs to gather a team of other professionals to help with the IPO. These include lawyers, regulatory experts, certified public accountants, and more.
- Due Diligence: This involves gathering all the required documentation for the IPO to go ahead. Investment banks do thorough background research into the company and management. This is in order to mitigate risks during the IPO launch process, which could cause price shocks or volatility. During this step, the underwriters will also register the company with the country’s regulatory authority. For this, documents such as letters of intent, engagement letters, and underwriting agreements may be needed. Other agreements such as best efforts agreements, firm commitment agreements, and all or none agreements are also signed at this stage.
- Marketing and Revision: At this stage, the company may begin creating marketing material for the IPO. This is in order to spread the word, as well as assess demand, which helps in deciding a final price for the launch. Banks make financial analysis revisions if necessary. The date of offering also changes in some cases.
- Forming a Board: During this step, the company forms a board of directors. It also sets financial reporting and auditing groundwork for future quarters.
- Issue of Shares: On the predetermined IPO date, the new shares go live. On the balance sheet, the capital received from the issue becomes shareholders’ equity. Banks communicate the IPO date well in advance to give investors enough notice to be ready.
- After the IPO: Following the offering, underwriters may try to stabilize share prices for the next 25 days. This is the quiet period. Investors who already had shares before the IPO, such as employees or friends and family, have additional restrictions. These usually prohibit them from taking advantage of IPO prices and selling shares for a certain amount of time, usually 90 to 180 days. This minimizes share price shocks. Other post-IPO provisions may also come into play at this stage
Pros and Cons of IPOs
Exposure to Public Markets
Initial public offerings open up access to a massive array of investors through public stock exchanges. This allows companies to raise a huge amount of capital, in several stages, for different purposes.
Better Reputation and Transparency
As a company becomes listed, its visibility and reputation improve, encouraging more deals and sales. It can also achieve better transparency through reporting requirements, attracting more investors and clients. This also strengthens its public image.
A number of qualified employees prefer to work at bigger, listed, and more stable organizations. This can mean that an IPO can often be the first step in attracting reputed and experienced talent. Such employees may stay with the company for years and contribute greatly to its future success.
Cheaper Access to Capital
Listed companies usually have better access to a number of cheaper sources of capital. This is because more of their financial and strategic information is easily available, with details of proven profitability. This allows banks and other lenders to feel more comfortable providing capital at lower rates.
IPOs can be very expensive, with accounting, legal, underwriting, and marketing fees quickly adding up.
The process can easily take months, with several revisions, updates, slowdowns, and regulatory obstacles. It can also take a long time to gather an IPO team, depending on the requirements and experience of the participants.
An initial public offering essentially dilutes the ownership of the company with several thousand or hundreds of thousands of investors. In some cases, this can cause issues regarding management and strategy down the line. Regaining ownership of the company is complicated, even though share buybacks can help.
More Reporting Requirements
Following listing, regulatory and reporting obligations increase accordingly. The company needs to prioritize transparency and ease of access to its records. It may also need to report to several regulatory authorities, especially if it operates overseas. Taxation liabilities become more complicated as well.
There are several factors that can affect the performance of an IPO.
- Underwriting investment banks play a huge role, as they may have created too much hype around the offering. This could cause some losses in the early stages.
- Lock-up periods can also significantly affect share prices in the few months following the offering. This is a period of time when early investors who had shares prior to the IPO cannot sell them. However, the time frame is only a few months. Thus, when the lock-up period is up, a number of early investors may sell large quantities of their stock, causing prices to plummet.
- Waiting periods are similar to lock-up periods but apply to investment banks, who may keep some IPO shares to buy after a specific amount of time. Banks may or may not ultimately buy these shares, which can affect their prices.
- The practice of flipping or re-selling initial offering shares within a few days to earn more may also affect share prices.
Examples of IPO Alternatives
Although the traditional IPO process is the most common, there are a few alternatives as below:
A direct listing is also known as a direct public offering or a direct placement. This means that the company chooses to bypass underwriters or intermediaries and sell its shares directly to the public. This can be through promoters, employees who already hold shares or existing investors. Direct listing usually involves existing shares rather than new ones.
Direct listings are much less expensive and time-consuming than IPOs. This is because companies don’t need to pay investment bank fees or follow the underwriting procedures and regulations. However, they also lose underwriting support and security as well as marketing benefits.
Smaller companies usually go for this option as they may not be able to afford underwriting fees. They may also not want to share dilution through a more public process. They also closely monitor the number of shares and investors, as well as the type of investors.
Special Purpose Acquisition Company (SPAC)
A special purpose acquisition company (SPAC) is a company created solely to purchase another company.
As such, the SPAC will launch an IPO and use the capital raised to buy the target company. Since, technically, the SPAC is now a public company, the acquired company also becomes public through it.
A SPAC has no other business function apart from this. However, they have increasingly gained popularity since they are faster and cost much less than initial public offerings.