Initial Public Offerings
An Initial Public Offering (IPO) is an exciting time when a privately-held company makes its shares publicly available for the first time. In the United States (what this piece will focus on), the shares are usually issued via a major stock exchange such as the New York Stock Exchange (NYSE) and facilitates the raising of capital for a company. Prior to going public via an IPO, a company will have a small number of shareholders, typically made up from the founders, their friends and family, and investors such as venture capitalists and/or angel investors. There are numerous benefits, as well as cons or risks, to deciding to take a company public. In terms of the positives, it allows for capital to be raised without taking on more debt compared to typical leverage (this is due to the nature of equity financing via share issuance rather than debt financing), lowers the cost of capital for a company, and can increase the company’s public exposure and image in a positive manner that could lead to increased profits. In terms of the downsides or risks, the company must publicly disclose financial documents (open to competitors to analyse), the taking-on of costs involved in potential additional marketing, legal and accounting activities, that the desired level of funding is not raised to result in a lower value stock price, a loss of ownership power, and increased legal/regulatory risk. Now that we have a level of understanding about what an IPO is and its associated risks/rewards, let us turn out attention to the timeline of an IPO, including the key critical events.
Key Critical Events and Time-Points for an IPO
There are 5 key steps a company must take in order to instigate an IPO; selection of a bank, due diligence and filings, pricing, stabilization, and finally the transition. The selection of an investment bank is important for the advice on the IPO, and most importantly, for the underwriting services. Underwriting is the practice of an investment bank in guaranteeing a specified number of shares will be sold, buying the surplus shares itself if need be.
The underwriting is tied into the due diligence process, which involves careful examination of all material relating to the company and its issuance of securities. Further, the process will involve determination of the company financials and an examination of management. The underwriter must draft up the following documents: an engagement letter (which includes a reimbursement clause), a letter of intent, the underwriting agreement, a registration statement (containing a prospectus for investors and private filings to the SEC), and a red herring document with details of the issuing company minus the offering date of share price.
Once the IPO has attained SEC approval, a date for the offering can be established, and a price is determined by the underwriter the day prior to the IPO. The underwriter will also determine the number of shares to be issued. Offering price can be determined by a variety of factors such as the current condition of the market economy (i.e. bull or bear), how successful pre-IPO roadshows are with potential investors, the public image of the company at large, company growth potential, current market prices of competitors, the management structure, and investor confidence in the business plan.
After-market stabilization occurs next, and is a process whereby the underwriter will purchase shares if demand for the stock looks weak, in an effort to stabilize the stock price. Part of this process also involves providing analyst recommendations to buy shares in the company during the IPO. This is of course a form of market manipulation, a practice normally illegal. However, the SEC allows for a limited level of market manipulation during a limited window in the IPO process, which falls under Regulation M. Generally, stabilization is carried out under a so-called greenshoe option (known formally as an over-allotment option), which gives the underwriter the right to buy an additional 15% of shares at the offering price.
Finally, a transition to market competition occurs 25 days after the IPO and the SEC-mandated ‘quiet period’ ends. Investors move from reliance on the investment prospectus to market forces and its related analysis. After the aforementioned 25 day quiet period ends, the underwriter can generate estimates for earning potential and company valuation, essentially transitioning to the role of an advisor to the markets
In terms of evaluating if an IPO has been a success, a traditional measure was to look for a 2-digit increase, or a doubling of share price within the first 24 hours. However, McKinsey & Co analysts reason that other measures need to be considered. These include an evaluation of market competitiveness compared to peers. This can be assessed by looking for a market cap equal to or exceeding that of the peers of the recently publicly-made company, 30 days after its IPO. Secondly, and also within this aforementioned time window, the market price should be assessed to see the change between the offering price and the market price. As the corporate finance institute states, ‘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%’.
Here we have briefly examined what an IPO is, why it is carried out, the pros and cons associated with going public, and the process that needs to be followed, at least within the United States. Additionally, we considered measures to assess whether or not an IPO has been a success. This is particularly important since some estimates place a mere 8% of IPO’s to be deemed positively competitive and offered at a fair market price. Therefore, it behooves prospective IPO-investors to garner a reasonable level of knowledge about any company going public they may want to invest in, and to understand the process, and how to value said investment.