Initial Public Offering (IPO) – Explanation

Cite this article as:"Initial Public Offering (IPO) – Explanation," in The Business Professor, updated January 14, 2015, last accessed June 7, 2020, https://thebusinessprofessor.com/lesson/what-is-an-initial-public-offering/.
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Initial Public Offering
This video explains what is an Initial Public Offering or IPO.

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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

A company is said to be taken public when it registers its shares with the Securities and Exchange Commission and sells those shares to investors on the public market. Going public generally requires the assistance of an investment bank and law firm (securities lawyer).

The Process of Going Public

    1. Approval by the Board Members – This requires a majority vote or unanimous consent of the directors.

Setting Up the Team: Assemble a team to carry out the initial public offering process. Cross-check the Financial Data: Following approval by the board of directors, the financials for the previous five years are reviewed and rewritten to comply with the Generally Accepted Accounting Principles (GAAP). Acquiring a letter of intent from an investment bank: Pick an investment bank and issue it a letter of intent in order to formalize the relationship and have proper contractual proof of the fees charged by the investment bank, their offering size, and price ranges among other things. Make a draft prospectus: The security lawyers and the accounting firm will have to prepare a prospectus. A prospectus is a written document that provides investors with a selling offer and a disclosure document. A prospectus must include:

    • Brief description of the business
    • A vivid explanation of the management structure of the firm
    • Total disclosure of the management compensation
    • Disclosure of the transactions between the management and the firm
    • Names of principal shareholders and their respective skates in the company
    • Audited financial statements
    • Brief discussion on the company operations and the financial health of the firm
    • Information on the purpose of the offering proceeds
    • Brief discussion on the effect of liquidating on previous stocks
    • Total breakdown of the firm’s dividend policy
    • Description of the firm’s capitalization
    • Brief description of the underwriting agreement and contracts
  1. Due Diligence: The company’s investment bank and accounting firm will analyze the firm’s management, its operations, the financial health, its edge against competitors and the business plans and objectives. They’ll also take a look at the firm’s labor force, its suppliers, and the customers, as well as the overall industry performance. In most cases, whatever are the results of such analysis would be used to determine changes that would be made to the prospectus.
  2. Preliminary prospectus presentation to the SEC: A preliminary prospectus is required by the SEC and authorized stock market regulators. The state securities commissions may also be required to sign this prospectus. The SEC would usually provide comments on the prospectus, most times in a form of extra disclosure.
  3. Syndication: After the preliminary prospectus has been filed with the SEC, the investment bank would then assemble a syndicate of other investment banks, with each taking on the responsible of selling portions of the offerings to interest investors. The share prices range is also narrowed down by the syndicate.
  4. Road Show: This is the act of meeting or holding different meetings with potential analysts and investors by the management or investment banker. The roadshow is a formal representation by the company’s management on the financial health of the firm, its operations, its performance, markets, and the provided goods and services. This is where the potential investors also ask questions or make standard inquiries about the firm.
  5. Finalization of the prospectus: The prospectus needs to be reviewed and amended according to SEC recommendations. Whenever the SEC states that the registration is effective, then the company can print and release the prospectus.
  6. Deciding the price and the size of the offering: A day before the registration of the company as a public firm becomes effective and valid, the offering would receive price bids. This is where the investment banker comes into play. The investment banker in this case would recommend a price for the firm’s approval. The price would be created from information about the firm’s performance, the prices of competitive offers and the market and industry condition among others. The investment banker can also make useful recommendations concerning the offering size, while considering the principal needed, demand on the part of investors, and the total controlling power which an offering will have over the firm.
  7. Print and Publish: After all the processes have been completed, a financial printer that is familiar with SEC’s regulations and rules on graphics will be required to make a written copy or written copies of the prospectus needed to launch the initial public offering (IPO).

IPOs offer the following advantages:

  • Raising Capital – IPOs raise large sums of capital for the issuing firms.
  • Low Borrowing Rates – Bring down the cost of capital for the issuing company that’s now in the public sphere.
  • Liquidity – IPOs raise the liquidity factor of stocks as publicly traded shares can be easily offloaded in the market.
  • Hiring – Stock options attract top tier talent looking for employee stock option plans.
  • Brand Recognition – IPOs raise brand awareness amongst the public, lenders, banks, etc.
  • Acquisitions & Mergers – Mergers of publicly traded companies are easier as IPOs help secure finances and raise capital.

IPOs also have a few drawbacks:

  • Regular Reporting – Publicly traded companies need to make information on finances, operations, profits, etc., public periodically on a regular basis.
  • Expenses: Managing the financials of a publicly-traded company is much more costly and cumbersome than a privately held firm.
  • Legal: Securities Exchange Commission, accounting firms and more agencies are involved in regulating a publicly-traded company according to the Securities Act of 1934.
  • Diluted Power: Proprietors may not retain the same kind of voting power in a publicly held company, leading to a loss of control on the company’s direction, operations, and goals.
  • Failed IPOs: IPOs that do not live up to forecasted expectations, incur heavy losses for the issuing company.

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.
Academic Research on Initial Public Offering

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