Initial Public Offering is the process in which the shares of the private companies are listed for the first time in the stock exchange for allowing trading of its shares to the public and this allows the private company to raise the capital for different investments.
On 6th May 2014, Chinese E-commerce heavyweight Alibaba filed a registration document to go to the public in the US in what may be called as the mother of all Initial Public Offerings in the US history. Alibaba is a fairly unknown entity in the US and other regions, though its massive size is comparable or even bigger than Amazon or eBay. Reading through Alibaba’s S-1 Filing was very interesting, educating and makes me realize how big their business is and how complex is the Chinese Internet Web.
IPO is one of the most popular terms in the world of business. In this article, you will get to know everything about the IPO process and how it works. In this article, we will talk about the following –
- What is Initial Public Offering or IPO?
- How the IPO Process Works?
- Factors to be considered before going for an IPO Process
- Example of the IPO Process
- Forced Initial Public Offering
What is Initial Public Offering (IPO)?
IPO stands for “Initial Public Offering”. In layman’s language, the definition of IPO is that it is a process of selling the first shares of a private company to the public.
Let’s take an example to understand this.
- Michele has a bookshop which is very profitable. She keeps all the ancient books from old times and she has a decent amount of loyal customers. She feels that she needs to expand her business so that she can go to different cities where more people would love her collection.
- She has a profitable business, but she doesn’t have the money in hand to build more stores in different cities. And she also doesn’t want to go for debt. Hence, she decides to go for Initial Public Offering.
- She contacts a local investment bank and the investment banks value her bookstore. The investment bank finds out that the valuation of her bookstore is $400,000. And they advised Michele that she should go for IPO of 20,000 shares by offering each share at $20.
- Michele decides to keep 50% ownership and issues the rest of the shares at $20 per share. Michele sells out all of her shares and now she has $200,000 to build more stores in different cities. Michele builds up 4 stores in 4 cities and becomes more profitable ever since.
The purpose of Initial Public Offering is to create funds by selling the company’s shares to the public. It’s the best way out to those who don’t want to go for long term loans.
How Initial Public Offering Works?
An IPO is not only an indication that a private company needs more capital to fuel its growth; it’s also a symbol that the business has made its mark on the world map.
Not all businesses go for an Initial Public Offering. Only a few who feel that they are competitive enough to go big, only go for initial public offering. But IPO is not all a bed of roses. With the recent Sarbanes-Oxley Act (in 2002), IPO has become an arduous process that not only costs the business more money; but also more regulatory requirements which very few companies can crack.
Having said that, there are the following steps you need to take if you would like to take your private company to the public –
#1 – Decide why you are going for an IPO
We know that the reason you are going for an Initial Public Offering is to raise money. But why you want to raise money? Do you want to expand your business? Do you want to go for backward integration or forward integration? Do you want to diversify your business? No matter what reasons you have, count them in and go to the next step.
source: Alibaba S1 Filings
#2 – Hire an investment bank
Once you have clarity on why Initial Public Offering is an essential option, the next step is to find out an investment bank that can work as an underwriter for your IPO process. This step is critical. Because there is a lot that depends on the investment bank. So before selecting the bank, choose whether the bank has any previous record of conducting an Initial Public Offering. Having experience in conducting IPO will take away a lot of burden from your shoulder.
#3 – The work of the underwriter
Once the investment bank is hired, it acts as an underwriter. The underwriter decides the value of the company and how much investors are willing to pay for shares in the company. After that, the initial public offering (IPO) is planned out and at pre-decided price company’s shares hit the stock market. Then the individual investors will purchase shares and the company will get news funds. The entire transaction is first funded by the investment bank so that the company has enough funds before the IPO.
source: Alibaba S1 Filings
#4 – Thoughts on contrast
The IPO process usually takes months to complete. And in some cases, Initial Public Offering is not always successful. Who will need to bear the cost then? The sad part is even if Initial Public Offering becomes unsuccessful, the cost has to be borne by the company and it usually costs them around $300,000 to $500,000. The cost needs to be incurred for printing, legal matters, and accounting fees, etc.
#5 – Due diligence
If you want to make your Initial Public Offering successful, first go in the market and find out whether your idea of expansion or diversification is a great idea. Ask your customers. Find out from the competitors. Primary research is much more important than secondary research. So invest first in primary research and record your findings. Then compare the findings with secondary research and see whether you can see any trend. If yes, follow along. If not, go deep and find out more. Due diligence is critical for your IPO because it will ultimately decide whether the IPO would be successful or not.
#6 – Places to go public
After all this preparation, it’s time to know where you will go public, i.e. stock exchanges. There are a few options for you. First is, of course, NYSE (New York Stock Exchange). There is also an AMEX (American Stock Exchange). You can choose NASDAQ (National Association of Securities Dealers Automated Quotations) as well. Other options are OTCBB (Over the Counter Bulletin Board) and the Pink Sheets. Depending on the need of the hour you can choose what stock exchange will suit you. For example, many start-up companies choose Over the Counter Bulletin Board and the Pink Sheets because there is no requirement for asset or revenue. As they grow in revenue and asset, they grow up the ladder and choose higher rung.
source: Alibaba S1 Filings
#7 – Final thing
While going for an IPO process, there is one thing most companies neglect, i.e. running their businesses. An Initial Public Offering is a very time-consuming thing that takes up all of the time and as a result, the main thing gets ignored. So, chalking out a plan to run your business effectively while you hustle for IPO is an essential thing. Otherwise, during the process, you may lose out a decent portion of the revenue.
Factors to be considered before going for an Initial Public Offering
There are a few factors that you need to consider before going into an IPO Process. All of these factors are important if you want to make your IPO a successful one.
- Historical records of the underwriter: It is of utter importance. Because they will ultimately direct and shape the IPO. You need to find out whether the investment bank has the right experience of conducting an IPO. A successful IPO process needs a lot of due diligence. And the first of which should be finding out about the investment bank. Incurring more than $300,000 for Initial Public Offering plus the underwriting commission is a big deal and your bank should know how to conduct the entire process without any hassle.
- Products & services offered by your firm and their potential: Your business would be as good as the future potential of your services and products. So it’s important for you to know what sort of image you have in the mind of your customers. Do they think highly of you when they think about your products and services? Do you provide value for a niche market or a mass-market? Who are your customers? How do you see your market in 5-10 years down the line? These are the questions you should ask before you ever say yes for IPO. Initial Public Offering is a process for getting the money in. But first, you need to incur a lot of money. You need to make sure your products and services are worthy of investing in future returns.
- Potential project value: An Initial Public Offering has value when it is going to give you more returns than invested. So, you need to consider what would be your ROI at the end of the day before going into this cumbersome process. Look, an IPO takes months and a lot of money and a lot of people. Until and unless you are absolutely confident about its returns, you shouldn’t go for it. A wasteful IPO doesn’t make sense. What’s worse is an IPO which takes away money from your pocket without giving you a dime in return!
- Mitigation of risks: An Initial Public Offering consists of so many risks. First of all is whether it would be a successful one? Whether the public would be interested enough to lend their money in lieu of your shares? And whether at the end of the day your purpose of conducting an IPO becomes successful? Understanding and mitigating risks would be of utmost importance. Know the risks, take steps to mitigate them as much as you can and then jump in. The best way to mitigate risks is to do your research. And invest more in research than in regret.
Example of the IPO Process
We can pick up any great company and tear the facts up to see what worked for them and what didn’t. Let’s take Facebook and dive in.
- Facebook Initial Public Offering is one of the biggest IPOs ever. On 1st February 2010, Facebook filed for an IPO by their S1 document with the Securities and Exchange Commission (SEC). Their prospectus showed that at that time they had 845 million monthly users with over 2 billion likes and comments daily.
- After the IPO, Mark Zuckerberg retained 22% of ownership share and 57% of voting shares. At the time of IPO, they wanted to raise $5 billion. The valuation went weary at times as many pundits gave many valuations. Ultimately Facebook shares were priced $38 per share which is more than its target range. At that price, Facebook was valued $104 billion. It was the largest valuation to date in the history of newly public companies.
- The Initial Public Offering of Facebook occurred on 14th May 2012. On 16th May, Facebook announced that it would sell 25% more of its shares due to huge demand. This has helped Facebook debut with 421 million shares.
- At the end of the week, Facebook closed its Initial Public Offering at $26.81 per share. Its PE ratio was staggering, a whopping 85 in spite of reduced revenue and earnings in the first quarter of 2012.
Forced Initial Public Offering
- In certain cases, companies are forced by the Securities and Exchange Commission (SEC) to go for an initial public offering. And that is called “Forced Initial Public Offering”.
- In normal cases, when a company more than $10 million assets and more than 500 shareholders, the company needs to disclose information publicly. Few companies don’t want to do that because it may increase the cost and people would start to notice more and more.
- The purpose of the SEC is to save the interests of the investors of the company. And that’s the reason in cases like these SEC forces the companies to go for Initial Public Offering so that they are bound to disclose all the information publicly and in a timely manner.
Initial Public Offering isn’t for all companies. And not all Initial Public Offerings are successful. There are many instances where IPOs failed or didn’t do that well as expected.
As big companies are captured by media and they already have funds to run a successful Initial Public Offering, hire a great underwriter and as a result ensure a smooth flow of issuing of shares. So we know that they are successful and we seem to believe all are successful. But the truth is darker than it seems. For example, if you look at the statistics of Apigee Corporation, Bellerophon Therapeutics LLC, Zosano Pharma Corporation, MaxPoint Interactive Inc., etc. you would see that the list of failed IPOs is much longer than it seems.
Initial Public Offering Video
This has been a guide to what is Initial Public Offering or 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 –