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What is an Initial Public Offering

7. What is an “initial public offering”?

An initial public offering (IPO) refers to the registration and sale of stocks of a private firm or company to the general public. The primary purpose of the IPO is to generate operating capital for the company or to create liquidity by opening its stock for public trading on stock exchanges or in private (over-the-counter) transactions. 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:

What is the Underwriting Process?

Typically the company seeking capital through an IPO partners with an underwriting firm or investment bank. “Underwriting” involves hiring an investment bank (or group of investment banks) to market and sell company securities. The underwriter provides support, including determining the type of security to issue, the price to offer, the number of shares to open to the public, and the time frame for which stocks are open to public. The underwriter also facilitates the sale of shares to investors through process known as a “road show”. The underwriting may also guarantee the placement of a certain quantity of stocks at a given price. 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”. The underwriting bank will generally make 1 of 3 different levels of commitment to the issuing company:

  • Firm Commitment – A firm commitment is when the underwriting bank act as a dealer and takes ownership or responsibility of any shares that are offered but not sold as part of the IPO. In a firm commitment, the bank receives a profit by negotiating a purchase price from the issuing company that is lower than the share price for purchasers.
  • Best Efforts Commitment – If the underwriter makes a best-efforts commitment, she does not guarantee that all of the shares will sale in the issuance at said price. Further, the bank will not take ownership of any unsold shares.
  • Standby Commitment – In a standby commitment, the underwriter agrees to purchase any shares not sold in the IPO at the stated subscription price. The fee to the issuer for this type of commitment is generally higher than in a best efforts commitment.

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.

Steps in the IPO Process

When a company decides to start IPO process, there are multiple steps involved in an IPO. The underwriting firm or investment banking firm partnering with the company for IPO process facilitates the steps in the process.

  • Formation of an external team comprising of experts like underwriters, lawyers, certified accountants and exchange commission experts.
  • Compilation of information about financial performance and future plan of operations of the company undergoing IPO
  • Filling of prospectus and registration statement with Securities and Exchange Commission.
  • Underwriter publicly advertises the issuance and seeks to secure investors to purchase the shares.
  • Setting up a date on which IPO will be rolled out.
  • Issuing the shares to the institutional investors subscribing to the issuance.

What is the Registration Process?

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.

How Does the Solicitation of Purchasers Work?

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.

What are the Advantages and Disadvantages of an IPO

The advantages of an IPO are as follows:

  • Capital Raise – It is the easiest way to raise large amounts of capital.
  • Cost of Capital – Being a publicly scrutinized company usually results in lower borrowing rates.
  • Brand Recognition – Going public increases the company’s brand recognition among lenders, suppliers, customers, etc.
  • Liquidity – Shareholders prefer for their ownership interest to be liquid (easily sold for cash). A public company’s shares can be easily sold on the public market. This makes it easier to attract top executive talent with employee stock option plans.
  • Mergers and Acquisitions – In a merger of two companies, having one or both companies as a public company can facilitate the process in terms of securing financing and trading stock in the deal.

The Disadvantages of and IPO are as follows:

  • Reporting – The company must make routine disclosures (finances, accounting, operations, legal, etc.) to the public.
  • Regulation – Public companies are highly regulated by various agencies primarily implement the Securities Act of 1934.
  • Expenses – The accounting, tax, and legal expenses of managing a public company are far higher.
  • IPO Failure – It is possible that the IPO price does not reach a minimum threshold and the IPO fails.
  • Loss of Control – Having a broad group of shareholders means that the existing owner’s interests are diluted. This results in a general loss of voting power and potential loss of control in the company.

References for an Initial Public Offering

https://www.investopedia.com/terms/f/firmcommitment.asp
https://en.wikipedia.org/wiki/Initial_public_offering
https://www.investopedia.com/university/ipo/ipo.asp

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