How Does an IPO Work?
Companies can only grow so much based on their sales and capital from owners and private investors. At some point in the maturity process, the owners may decide to take the company public as a way of unleashing its expansion potential. When this happens, the business will go through the following process.
Underwriting
Most companies are not in a position to sell their own stock publicly. Selling shares requires valuation, marketing, and the filing of specific regulatory documents. For these reasons, the company will enlist the help of an underwriter to guide them through the IPO process.
Underwriters are usually large investment banks and can help maximize returns for the company offering the IPO. They have a great deal of experience in performing financial audits and determining valuation. These banks also have their own network of institutional and private investors whom they can use to promote interest in the IPO.
Create a Prospectus
Based on advice from the underwriter, the company will then create a prospectus. A prospectus is a financial document that will be circulated to potential buyers of the IPO shares.
The underwriter will generally take the IPO company on what's called a "roadshow". This is a series of meetings with major investors where the goal is to create as much demand as possible for the new IPO shares. Investors who would like to buy will be asked to submit an indication of interest. Gauging the level of demand can also help determine how much the initial share price should be at the IPO.
Form a Syndicate
Another key role of the underwriter is that they will often serve as the middleman between the company going public and investors. They will do this by buying the IPO shares and then reselling them to investors.
Underwriters will buy the shares for less than the price advertised to investors. Depending on how much demand there is for the IPO, this can be a very lucrative transaction for the underwriter.
Often times to reduce risk exposure, the underwriter will enlist the help of other investment banks in the IPO process. This network of banks is referred to as a syndicate.
Meet Regulatory Requirements
Unlike private companies, public companies must go through government screening before they can sell to the public. This is done to protect public investors from investing in businesses that are illegitimate. In the U.S., federal standards are set forth by the Securities and Exchange Commission (SEC).
Before the company can officially go public, it must apply for the IPO with the SEC by submitting a Form S-1. A Form S-1 typically consists of a portfolio of information containing the company's prospectus and other financial documentation. The SEC will audit the company and validate its authenticity.
Note that even after the IPO, the company must continue to publish financial statements and file them with the SEC regularly. Otherwise, it can be grounds for the stock becoming delisted which would drop the value of the shares significantly.
Hold the IPO
Once the issuing company receives approval from the SEC, the IPO date will be set. On this day, there is often a lot of media attention and excitement as investors eagerly await to see how the sale goes.
On the day that the IPO is held, shares will typically not be available to regular investors. Generally, only accredited investors (those with a net worth of $1,000,000 excluding primary residence or a gross income exceeding $200,000 / $300,000 depending on if they file a single/joint return) will be given the opportunity to directly participate in the IPO. The more common way for individual investors to buy shares is shortly after they've been resold by those who bought from the IPO directly.
Follow-On Offerings
An IPO is not the only time that a company sells shares to investors. They can also do so during a follow-on offering (FPO); also sometimes called a secondary offering. FPOs are the issuance of stock shares following a company's IPO.
Shares in FPOs may be diluted or non-diluted. Dilution means that new shares have been created. This will be important for investors to know because it will result in a lower earnings per share (EPS) value.
Alternatives to an IPO
While IPOs may be a buzzword among investors and Wall Street, it's not the only way for a company to go public. Businesses can use the following alternative methods if it better suites their needs:
Direct Listings
Also known as a direct public offering (DPO), direct listings are when a company begins selling its shares to the public without the assistance of an underwriter. This will be done by selling the shares it already has and not creating any new ones. Companies may choose to utilize a direct listing if they don't have the resources to pay an underwriter.
Dutch Auctions
A Dutch auction is a specific type of IPO where investors bid for the number of shares they want to purchase and the price they're willing to pay. The winning bid will be based on the total overall offering that can be sold (price x number of shares).
Initial Coin Offering (ICO)
ICOs are the equivalent of an IPO where the business (generally a technology company) will issue cryptocurrency to investors in exchange for capital. This can be a quick and fast way for the company to raise new funds. However, because cryptocurrency is unregulated, there is no government oversight or protection for these investors. Therefore, ICOs should be considered extremely risky.
The Bottom Line
Initial public offerings are how companies go from being privately owned to publicly traded in the open stock market. To get there, most businesses will enlist the help of large banks to serve as their underwriters to guide them through the process and drive up demand for the shares. They must also pass SEC requirements and file the proper documentation.
IPOs can help raise a lot of necessary capital for a business as well as give it a prestigious public image. Investors also like IPOs because of the prospect of “getting in on the ground floor” by acquiring shares at their potentially lowest price. However, not all companies are guaranteed to succeed, and investors should exercise due diligence.