Initial Public Offering (IPO) Definition
An Initial Public Offering (IPO) is the process of selling a company’s stock to the public for the first time. Before the IPO the company is private; after the IPO the company is public. The IPO process is typically underwritten by a syndicate of investment banks. The process follows several steps, described below.
Advantages and Disadvantages of IPOs
Going public has at least two advantages: greater liquidity of equity and access to a larger pool of capital. There are at least three disadvantages to going public: dispersion of control, required adherence to regulations and public scrutiny.
The IPO process includes the following steps:
1. The company chooses a syndicate of underwriters (see below)
2. The company and the underwriters compose a preliminary prospectus (see below)
3. The SEC reviews the prospectus and approves the IPO
4. The underwriters determine the value of the firm and the structure of the IPO
5. The underwriters go on a road show to gauge investor interest in the IPO (see below)
6. The investors express level of interest and the underwriters set the offer price
7. The securities are distributed to the public (see below)
In the IPO process, the underwriters – a syndicate of one or more investment banks – are responsible for registering the IPO with the SEC, valuing the company that is going public, structuring the issuance of securities, pricing the securities, and marketing the securities to potential investors. The underwriters also bear the risk of distributing the securities.
The preliminary prospectus, or red herring, is a legal document that must be submitted to the SEC for approval prior to an IPO.
The document includes details about the company, including an explanation of the company’s operations and competitive position, and copies of its financial statements. The document also includes the details of the IPO, including the type of security (common stock, preferred stock, etc.) to be offered, the number of shares to be offered, and the anticipated share price.
A road show is when the underwriters travel the country, or the even the world, to pitch the IPO to potential investors. The idea is to determine whether investors are interested in the offering. And if so, then they need to determine how many shares they will purchase and what price they are willing to pay. The investors are typically large institutional investors – mutual funds and pension funds.
Underwriters take on significant financial risk when they commit to an IPO. If the market is not interested in the offering, then the underwriters may be stuck holding securities nobody wants.
In order to ensure market interest in the offering, underwriters will often deliberately under-price the securities for the initial public offering. They sell it for cheaper than it is worth. So when the shares go public, investors buy up the bargain-priced shares. This causes them shoot up in value on the first day of trading. You may know this as the “IPO pop.”
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