7. What is an “initial public offering”?
An initial public offering is the process by which a company first sells an equity interest in the company to the public at large. The primary purpose of the IPO is to generate operating capital for the company. Equity shares in a company constitute securities, so the IPO process is subject to securities law and is closely scrutinized by the SEC. The IPO process is complicated and generally involves a number of professional service providers. The process for an IPO is substantially as follows:
• Underwriting – “Underwriting” involves hiring an investment bank (or group of investment banks) to market and sell company securities. In some instances, smaller companies will make an offering directly to individual customers through a licensed broker. This process is known as a “direct public offering” and is often associated with low-value securities, commonly referred to as “penny stocks”. For larger companies, investment banks stand in a unique position to be able to create awareness of the issuance and sell the securities to large, institutional investors. This process is commonly known as a “road show”. In some instances the bank will purchase shares from the company and then resell them to investors in pre-arranged transactions on the open market. In this situation the bank is making a “firm commitment” as underwriter. The bank will often keep a percentage of the shares for itself as compensation for the underwriting process. In other arrangements, an underwriter may simply act as a sales agent for the issuer. The bank may guarantee a limited number of sales, but generally it does not guarantee any specific number. This is known as a “best efforts commitment”. The bank earns a commission on the number of shares sold. The underwriter assists the issuer in determining the price and number of shares to issue.
⁃ Note: The underwriter has the ability to garner interest in the securities, but no sale of securities can take place at this point. The issuer can only sell to the underwriter or to prospective purchasers identified by the underwriter once the registration process is complete.
⁃ Example: ABC Corp intends to undergo an IPO and needs assistance with arranging for the sale of its shares to the public. JP Morgan Bank contracts with ABC Corp to handle the IPO. JP Morgan will advise ABC Corp on the number and value of shares to issue. It will then seek to sell (seek commitments for the purchase of) these shares to institutional investors. JP Morgan makes a firm commitment, so it is obligated to purchase a predetermined number of shares, which it will sell to the institutional investors for a price above what it pays ABC Corp.
• Registration – Registration is the process of filing extensive disclosures with the SEC about the companies finances and operations and characteristics of the issuance of securities. The filings with the SEC are made public and provide information to potential investors in the market. The SEC will review the disclosures for completeness, but it does not evaluate the quality of the securities being issued. The approval of the SEC is based upon whether sufficient information is disclosed to allow a potential investor to make an informed decision. Often this is a back-and-forth process until the SEC is satisfied that all necessary information has been disclosed.
⁃ Note: Disclosure to the SEC is a very complicated process. Though expensive, businesses generally hire experienced legal firms to help with the disclosure process. Private sale of securities (discussed below) may be exempt from the registration process.
• Solicitation of Purchasers – After the registration process is complete, the issuer will solicit prospective purchasers and consummate the sale of securities. At this point, the investment bank will proceed with the road show and begin contacting potential purchasers. As part of this process, the issuer or underwriter must provide all offerees or prospective purchasers with a disclosure document, known as a “prospectus”. The prospectus contains much of the same information contained in the registration statement but provides a more concise presentation of material information.
The extensive registration requirements associated with an IPO can be very burdensome and expensive to the company. As such, many companies seeking to raise capital avoid the IPO process and seek equity financing from private investors. This process is known as a “private offering” and is discussed further below.
• Discussion: How do you feel about the extensive registration requirements and sale restrictions on securities? Are these regulations a benefit or detriment to businesses? Society? Why or why not?
• Practice Question: Ernest is interested in offering shares of his company, ABC Corp, for sale to the public. He believes that this will bring in the capital necessary to continue growth. Outline the securities law process that ABC Corp will need to undergo prior to selling to the public.