IPO stands for initial public offering. In an IPO, a privately owned company lists its shares on a stock exchange, making them available for purchase by the general public.
What is IPO/ Initial Public Offering?
An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance for the first time. IPO allows a company to raise equity capital from public investors.
In essence, an IPO means that a company’s ownership is transitioning from private ownership to public ownership. For that reason, the IPO process is sometimes referred to as “going public.”
Startup companies or companies that have been in business for decades can decide to go public through an IPO.
Companies typically issue an IPO to raise capital to pay off debts, fund growth initiatives, raise their public profile; or allow company insiders to diversify their holdings or create liquidity by selling all or a portion of their private shares as part of the IPO.
In an IPO, after a company decides to “go public,” it chooses a lead underwriter to help with the securities registration process and distribution of the shares to the public.
The lead underwriter then assembles a group of investment banks and broker-dealers (a group known as a syndicate) that is responsible for selling shares of the IPO to institutional and individual investors.
Key Points:
An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.
Companies must meet requirements by exchanges and the Securities and Exchange Commission (SEC) to hold an IPO.
IPOs provide companies with an opportunity to obtain capital by offering shares through the primary market.
Companies hire investment banks to market, gauge demand, set the IPO price and date, and more.
An IPO can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment.
How Does an IPO Work?
Going public is a challenging, time-consuming process that’s difficult for most companies to navigate alone.
A private company planning an IPO needs not only to prepare itself for an exponential increase in public scrutiny but also to file a ton of paperwork and financial disclosures to meet the requirements of the Securities and Exchange Commission (SEC), which oversees public companies.
That’s why a private company that plans to go public hires an underwriter, usually an investment bank, to consult on the IPO and help it set an initial price for the offering.
Underwriters help management prepare for an IPO, creating key documents for investors and scheduling meetings with potential investors, called roadshows.
Once the company and its advisors have set an initial price for the IPO, the underwriter issues shares to investors and the company’s stock begin trading on a public stock exchange, like the New York Stock Exchange (NYSE) or the Nasdaq.
Importance of IPO?
There are other reasons for a company to pursue an IPO, such as raising capital or boosting a company’s public profile:
Companies can raise additional capital by selling shares to the public. The proceeds may be used to expand the business, fund research and development or pay off debt.
Other avenues for raising capital, via venture capitalists, private investors or bank loans, may be too expensive.
Going public in an IPO can provide companies with a huge amount of publicity.
Companies may want the standing and gravitas that often come with being a public company, which may also help them secure better terms from lenders.
Steps in Initial Public Offering
Proposals. Underwriters present proposals and valuations discussing their services, the best type of security to issue, the offering price, the amount of shares, and the estimated time frame for the market offering.
Underwriter. The company chooses its underwriters and formally agrees to underwrite terms through an underwriting agreement.
Team. IPO teams are formed comprising underwriters, lawyers, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) experts.
Documentation. Information regarding the company is compiled for required IPO documentation.
The S-1 Registration Statement is the primary IPO filing document. It has two parts—the prospectus and the privately held filing information. The S-1 includes preliminary information about the expected date of the filing.
It will be revised often throughout the pre-IPO process. The included prospectus is also revised continuously.
Marketing & Updates. Marketing materials are created for pre-marketing of the new stock issuance. Underwriters and executives market the share issuance to estimate demand and establish a final offering price.
Underwriters can make revisions to their financial analysis throughout the marketing process.
This can include changing the IPO price or issuance date as they see fit. Companies take the necessary steps to meet specific public share-offering requirements.
Companies must adhere to both exchange listing requirements and SEC requirements for public companies.
Board & Processes. Form a board of directors and ensure processes for reporting auditable financial and accounting information every quarter.
Shares Issued. The company issues its shares on an IPO date. Capital from the primary issuance to shareholders is received as cash and recorded as stockholders’ equity on the balance sheet.
Subsequently, the balance sheet share value becomes dependent on the company’s stockholders’ equity per share valuation comprehensively.
Post-IPO. Some post-IPO provisions may be instituted. Underwriters may have a specified time frame to buy an additional amount of shares after the initial public offering (IPO) date. Meanwhile, certain investors may be subject to quiet periods.
Advantages and Disadvantages of IPO
The primary objective of an IPO is to raise capital for a business. It can also come with other advantages as well as disadvantages.
Advantages
One of the key advantages is that the company gets access to investment from the entire investing public to raise capital. This facilitates easier acquisition deals (share conversions) and increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits.
Increased transparency that comes with required quarterly reporting can usually help a company receive more favorable credit borrowing terms than a private company.
Disadvantages
Companies may confront several disadvantages to going public and potentially choose alternative strategies.
Some of the major disadvantages include the fact that IPOs are expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business.
Fluctuations in a company’s share price can be a distraction for management, which may be compensated and evaluated based on stock performance rather than real financial results.
Additionally, the company becomes required to disclose financial, accounting, tax, and other business information.
During these disclosures, it may have to publicly reveal secrets and business methods that could help competitors.
Rigid leadership and governance by the board of directors can make it more difficult to retain good managers willing to take risks.
Remaining private is always an option. Instead of going public, companies may also solicit bids for a buyout. Additionally, there can be some alternatives that companies may explore.
Pros
Can raise additional funds in the future through secondary offerings
Attracts and retains better management and skilled employees through liquid stock equity participation (e.g., ESOPs)
IPOs can give a company a lower cost of capital for both equity and debt
Cons
Significant legal, accounting, and marketing costs arise, many of which are ongoing
Increased time, effort, and attention required of management for reporting
There is a loss of control and stronger agency problems
