Initial Public Offering (IPO) Meaning
An initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.
- Initial public offering (IPO) is defined as the debut of a private company on the stock exchange by issuing its shares for the first time to the general public.
- The shares are first issued in the primary market. Thereafter, they get listed in the secondary market which contains stock exchanges and over-the-counter (OTC) market. Once listed, the newly listed shares start trading amongst investors.
- For holding an IPO, the company typically has to file the S-1 Registration Statement with the SEC in order to comply with the authority’s requirements.
- It is a kind of exit strategy adopted by the angel investors, venture capitalists and other early-stage investors of a business to make high returns on their investment.
- The general public make gains from IPOs by acquiring shares at a low cost and selling them to other investors when the price rises.
Initial Public Offering Explained
The initial public offering helps startups and growing businesses in acquiring extensive capital from the market. A business can raise funds from relatives, angel investorsAngel InvestorsAngel investors refer to wealthy investors who supply capital to budding businesses in return for a portion of their equity. and venture capitalsVenture CapitalsVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. to only an extent. Besides, most of these sources invest intending to grab massive gains from appreciated share values when the startup goes public.
With an obligation to enable investors a fruitful return and to further expand themselves by raising funds from the most coveted source, businesses go public. A private company becomes public by offering its shares to the general public. However, there are many established companies such as State Farms, IKEA, etc., that remain private.
Initial Public Offering is desirable as it opens avenues for scalability with extensive funds. The process of IPO initially involves issuing shares in the primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer. through the help of investment banks. After legal filings, marketing and price computing, the shares are finally allocated. In due time, they begin trading on the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. in the secondary marketSecondary MarketA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets..
A company has to file an S-1 Registration Statement with the Securities and Exchange Commission (SEC) to issue the IPO as per the federal laws. In addition, it encompasses legal requirements to attain IPO eligibility. Also, post Initial Public Offering, stock exchanges hold distinct criteria to remain listed. For example, the NYSE requires the market value of post-IPO shares to be at least $40 million.
Initial Public Offering Process
The IPO process is a complicated business. Usually, a company takes the services of an investment bank that first sells the company’s shares to certain investors in the primary market. Following which, the shares debut on a stock exchange and start trading amongst investors. Another route is direct listing, when a company enlists itself on an exchange without an investment bank. Let us look at the step-by-step process of Initial Public Offering.
1. Deciding the reason behind the release of Initial Public Offering
At the initial stage, the company needs to ascertain the purpose of raising funds. Whether it is expansion, integration or diversification, the company should be clear.
2. Hiring an investment bank
The next step is to find an investment bank that can work as an underwriter for your IPO process. An underwriterUnderwriterThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there. helps the company fulfill financial and legal obligations. It also arrives at the company’s value, IPO price and sells the shares to the initial investors in the primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer.. It is essential to select an investment bank that holds expertise and proven experience in conducting Initial Public Offers.
3. Underwriting Tasks
- Financial details – The underwriter helps the company prepare its financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., and reports required for registration. It involves compiling revenuesRevenuesRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions., profits, total asset size, and other business figures including the company valuation.
- Legal requirements – A company can go public only after registering with the SEC. For this, the underwriter undertakes more paperwork to adhere to the regulatory compliance including clearly specifying the reason behind the IPO issue and risk factorsRisk FactorsRisk factors in Business are constituents, circumstances, or causes, responsible for interruption, or, disrupting the business activities or operations, expectations, plans, objectives, or strategies of a business or an investor.. If the SEC sends revisions, the company has to make necessary changes. Once approved from the SEC, the company can go public.
4. Conducting pre-IPO analyst research
- Here the company conducts extensive research for a successful Initial Public Offer. It indulges in primary research and records IPOs viability from the perspective of investors and competitors. Based on the trend it zeroes in on the right time to get listed.
- Looking for a stock exchange that is suited to one’s business capabilities is also a part of the research. Some options are NYSE (New York Stock Exchange), AMEX (American Stock Exchange), NASDAQ (National Association of Securities Dealers Automated Quotations), OTCBB (Over the Counter Bulletin Board) and Pink SheetsPink SheetsPink sheets are stocks that cannot be traded on exchanges such as NYSE/NASDAQ for a variety of reasons, including a lack of sufficient capital to go public, lack of economic justification for going public given the small amount of capital they intend to raise, or a strategic decision not to go public due to the scrutiny that the regulatory boards place on them..
5. Cost Computing
Throughout the process, the company has to keep a tab on its finances as going public takes a lot of capital. The company has to restrict the process within its means lest it offsets the gains from the IPO.
6. Marketing, finalizing the IPO price and allocating shares
- Marketing – Starting from marketing, the following are most important stages in initial public offering. During marketing, the management team promotes the IPO by connecting with the prospective investors. Prospectus is shared. The prospectus or offering document discloses the terms and conditions of the IPO, financial health, earnings, etc. Therefore, it is a crucial element for attracting the investors.
- Finalizing the IPO price – After marketing, investors send their indication of interest which reflects that they are interested in buying the company shares. The price per share can be modified as per the investors’ response. The IPO price is finalized here and also the share lot.
- Allocating shares – Lastly, the Initial Public Offer becomes good to go. The shares are allotted to initial investors who are predominantly institutional buyers in many cases. Retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making. also take part.
- Getting listed and stock trading – After initial allotment, the shares are debuted on an exchange where they trade between investors.
Initial Public Offering Stock Examples
Let us take a look at some examples to elucidate the process of the initial public offering.
Facebook Initial Public Offer
Facebook had registered its IPO documents by filing an S-1 document with the SEC. The company had 845 million monthly users as of December 2011, with $1 billion in profit. After intense marketing, Facebook shares debuted on NASDAQ in May 2012 at $38 each.
The offer price resulted in a sky-high company valuation at $104 billion, becoming the first US company at the time to go public at over $100 billion. The shares opened up at $45, 11% up from IPO price. However, experts suggest that technical delays and high valuation led the price to fall sharply. At last, Facebook’s underwriters jumped in and bought some shares, closing them at $38.23 on the first day.
Due to the huge demand, Facebook had decided to release more shares. As a result, a record shares 576 million shares were traded on the first day. Mark Zuckerberg had retained 28% of company shares at the IPO, which came down to 14% in 2020.
After a rocky start at the IPO, the company continued to rise by trading at over $300 per share in 2021 and its quarterly revenue being $26.17 billion.
Coinbase Initial Public Offer
Cryptocurrency exchange Coinbase got itself listed on NASDAQ in April 2021 with an impressive IPO. It had filed form S-1 Registration Statement the SEC quoting 43 million retail users and the December 31, 2020 revenues at $1.3 billion. Shunning the traditional IPO process, Coinbase undertook direct listing.
While the pre-emptive reference price of the Coinbase IPO as declared by NASDAQ was $250 per share, it opened at $381 on the first day. Then, the price further climbed to $429.54. Finally, however, it closed at $328.
Some anticipated upcoming initial public offerings of 2021 are Robinhood, Traeger, and Weber, among others.
Advantages and Disadvantages
Through Initial Public Offering, a company can avail colossal capital from the public. But, like everything, initial public offerings also come with advantages and certain disadvantages. Let us have a look at the major ones.
- Monumental earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. arising out of the IPO help businesses expand themselves and address monetary issues if any.
- Also, original investors such as venture capitalists and angel investors who had been holding certain shares of the startup make their exit. After the IPO, they sell their shares at a tremendous profit.
- Sometimes, the value of pre-IPO shares is higher than the company’s expectation due to hyping. It helps the company enter into accessible acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion. deals and minimize the capital cost.
- It allows favorable credit terms due to quarterly reportingQuarterly ReportingQuarterly reports are unaudited financial reports that are summarized versions of financial statements released by public companies every three months (quarter) to comply with compliance requirements. of financial statements. Executives and workers are compensated after the IPO when the business sales and revenue grow.
Let us look at some of the downsides of IPO.
- A significant risk is not getting a positive response from the investors towards the IPO and thus chances of inability to raise the desired capital.
- In addition, since the company becomes public, it has to reveal all its business information such as finances, team, revenue, tax, accounting, etc. This, in turn, may help the competitors gain an edge over the company.
- IPO is a costly business since a public company has to incur various non-operating expenses. Also, the overheads related to marketing, accounting, management and legal matters go up. Moreover, it consumes excessive managerial efforts and time to maintain the quarterly financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. as the company goes public.
- Other drawbacks are stringent legal and regulatory compliance requirements, loss of control, higher accountability towards shareholders, and changes in the board of directors.
- Companies are also thrown into adverse effects when their stocks are subjected to constant speculation post the initial public offering.
How Can Investors Trade Safely?
The SEC often advises investors to exercise caution around stock trading, especially with IPOs. Given below are some of the points an investor should consider before jumping into IPO trading –
- Thoroughly go through the company prospectus to understand its business, IPO purpose, dividend policyDividend PolicyDividend policy is the policy that the company adopts for paying out the dividends to the company's shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequent the company pays the dividend amount., risk factors, dilution, and financial condition.
- A public company needs to furnish Forms 10-K and 10-Q to disclose its annual and quarterly financial statements for transparency. It reveals the company’s financial health to shareholders which the investors must keep a tab on.
- Figure out the underwriter and company’s mindset behind setting a specific offering priceOffering PriceOffering Price is the price that is decided by an investment banking underwriter when a company plans to go public list shares in the stock exchange for raising capital. This price is based on the future earning potential of the company, however, the price shouldn’t be too high then the shares might not be sold in full and if it is too low then the potential to raise more capital is lost.. Look into market analysis, interpretation, condition and negotiation.
- Other essential elements to keep an eye on include hype, limited trading volumeTrading VolumeThe volume of trade is the overall measure of the number of securities, shares or contracts traded during a particular trading day. , non-traded outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet., company’s stage, emerging growth companies, separate classes of common stock and selling shareholders (who receive proceeds of their stocks sold in Initial Public Offer).
An IPO is a method adopted by a private company to debut its shares to the general public. As part of the IPO, the shares are initially sold in the primary market, following which they are made available for public trading on the stock exchange.
An initial public offering (IPO) involves high risks; therefore, you must always overlook the speculation of exceptional returns since they often hype up even non-potential stocks. However, if you go by the facts, i.e., conducting due diligence on the company’s background, scope, profitability, past performance and plans, it can reap terrific returns in the long run.
Retail investors can apply for the pre-IPO shares, either online/offline or through a stockbroker. It is mandatory to have a Demat account for such an application. The underwriter does the allotment of shares according to the bidding size (oversubscription or under subscription).
This has been a guide to what is Initial Public Offering (IPO). Here we discuss how it works and which factors you need to consider before conducting an IPO process. You may learn more about Investment Banking from the following articles –