IPO - Initial Public Offering

Raising capital is a major problem for any business; IPO is a solution to this problem. IPO allows the public to participate in the investment of the company, eventually increasing the capital of the company.

What is an Initial Public Offering?

Initial Public Offering is often abbreviated as IPO. Private companies offer shares to the public in order to generate capital from the public investors; this process is known as the Initial Public Offering (IPO). Therefore, public investors can also participate in the offering. While converting from a private to a public company, the private investors have a share premium. IPO acts as a win-win situation for both the company and the public investors. However, it may cause losses for any one of them or both.

Working of an Initial Public Offering (IPO)

A company has a small number of shareholders before the IPO, including investors such as the founder, family, friends, and private investors like the venture capitalists and angel investors. The IPO provides more opportunities for the growth of a company, and IPO allows a company to raise money through public investors.

It is necessary for a company to fulfil the requirements of the Security and Exchange Commission (SEC) for holding an IPO. A company announces to be public only after it is sure that it has reached a level at which it is ready for the SEC regulations. Additionally, it must be ready to take the responsibilities of benefits of public shareholders. It is achieved by a private company after it obtains a unicorn status which means that it has a private valuation of $1 billion. However, some companies can qualify if they have proven profitability potential and have strong fundamentals. It also depends on the market competition and whether they fulfil the listing requirements or not.

History of Initial Public Offerings (IPOs)

• Dutch East India Company offered the first IPO to the general public, and it was the first modern IPO. Therefore, the credit for the introduction of the IPO is given to the Dutch.
• Almost all the companies still use it to raise capital from public investors through the issuance of public share ownership.
• IPOs cause uptrends and downtrends in the issuance. However, other factors that cause uptrends and downtrends in issuance are innovation and economic factors, and these even cause uptrends and downtrends in the issuance of individual sectors.
• The tech IPOs significantly increased as start-ups began to list themselves on the stock market to raise capital.
• The least number of IPOs were observed in 2008, during the financial crisis. Even some years after the 2008 financial crisis, the number of new listings shrank.
• Nowadays, the focus of the investors has shifted to the unicorn status start-ups that have reached the limit of $1 billion. The investors and media closely monitor such companies and their decision of going public through IPO or remain private.

The process involved in Initial Public Offering (IPO)

The IPO primarily has two phases, first is the marketing phase of the offering, whereas the second phase is the initial public offering itself. The company advertises if it is interested in the IPO. It can even release a public statement to get people interested in the company shares.

The company selects the underwriter that is responsible for leading the IPO process. The company may choose single or many underwriters for different parts of the IPO process to manage the process collaboratively. The involvement of the underwriters is crucial in all aspects of the IPO, and these aspects are due diligence, documentation, marketing, filing, and issuance.

Steps of the IPO Process

IPO is an organised process that takes place in a series of steps that are monitored by the underwriters at every stage. Following are the steps involved in IPO -

1. Proposals: Underwriters discuss their services and present their proposal along with the valuation. They also discuss the security type to tackle the issue, amount of share, and offering price. Additionally, they estimate the time frame for the market offering.
2. Underwriter: A company goes through the underwriter agreement and agrees to its terms. The underwriters are selected by the company.
3. Formation of a team: Team of IPO comprises the Security Exchange Commission (SEC) experts, lawyers, underwriters, and Certified Public Accountants (CPAs).
4. Documentation: IPO documentation requires the information about the company compiled together. The primary filing document, the S-1 registration document, consists of two parts - privately held filing information and the prospectus.
   S-1 consists of the expected filing date, which is revised from time to time throughout the process of pre-IPO. The prospectus in S-1 is also subjected to revision on a timely basis.
5. Marketing & Updates: The creation of marketing materials takes place for the pre-marketing of new stock issuance. The demand is estimated by underwriters and executives as they market the share; this also helps them determine the final offering price. The financial analysis can be altered by the underwriters while the marketing process is in progress. It may include a change of the issuance date or IPO price according to the fit of the underwriter.
   Specific public share offering requirements are achieved through necessary measures by the company. Companies should adhere to the exchange listing and SEC requirements that need to be followed by the public companies.
6. Board & Processes: The process of reporting the financial and accounting information every quarter is endured and the board of directors is formed.
7. Shares Issued: IPO date is important as the company issues shares on this date. The capital is received in cash and recorded as equity of the stakeholder on the balance sheet. This capital is issued from primary issuance to stakeholders. Eventually, the company's stockholders' equity per share evaluation will affect the balance sheet share value.
8. Post-IPO: Underwriters may buy additional shares for a specified time after the Initial Public Offering (IPO) date. However, investors may be subjected to a quiet period. These are post-IPO provisions that are instituted.
   

Advantages and Disadvantages of an IPO

Although IPO raises the capital of the company, which is good for the company, still there are several other advantages and disadvantages of the IPO.

Advantages

The first and foremost advantage is that the company can raise capital as all public investors can participate in the investing. Furthermore, this can lead to more public exposure, better acquisition deals, increased prestige, and improved public image. Eventually, the sales and profit of the company go up.

The transparency of the company increases, also quarterly reporting is required that makes it easier for the company to get favourable credit borrowing terms compared to the private company.

Disadvantages

Many companies face several drawbacks while going public and thus prefer alternative strategies. The major drawback is the high cost of IPOs; the cost of maintenance of a public company is generally higher than that of a private company. Generally, these are not related to the cost of doing business.

The management starts focusing on the stock prices rather than the financial outcomes, which can be a distraction for the company. For the monitoring of the stock performance, the company has to reveal its data such as accounting, business information, finances and tax-related information. The need to reveal business secrets may arise, which can benefit the competitors.

There is also a possibility of a loss of good managers with risk-taking ability, which is generally due to the rigid governance of the board of directors. There are several other options that the company can choose from rather than going public. One such alternative is that the company may solicit the bids for a buyout.

Alternatives to the IPOs

Direct Listing

If an IPO is conducted without the underwriter, then it is known as a direct listing. The process of the underwriter is completely dropped, the issuer will have to face a greater loss, more risk. However, if the share price increases, there will be greater profit for the issuer. A direct offering is feasible only for a company that has a very attractive business and well-recognised brand.

Dutch Auction

The price of an IPO is not fixed in a Dutch auction. Buyers bid for the shares and specify the price they are willing to pay. The share is allocated to the bidder that bids the highest price for that share.

IPO Performance and Parameters Affecting

Many factors influence the IPO return, and it is closely monitored by the investors. Some IPOs may cause losses initially, as these may be over-hyped by the investment banks. However, short term gain can be expected while the IPO is introduced to the public. Some considerations that affect the IPO performance are listed below: -

i) Lock-UP

Sometimes, the stocks take a steep downturn; this may be due to the lock-up period expiration. The underwriters ask the officials and employees of the company (the company insiders) to sign the lock-up agreement while the company goes public.

The company cannot sell any share of stock for a particular period after the lock-up agreement is signed between the underwriters and the company insiders. The period for which the company is prohibited from such action is from 3 to 24 months. Rule 144 (SEC law) states the minimum lock-up period of ninety days. However, the underwriters may stretch it longer. After the expiry of the lock-up period, the price of the stock suffers. It is because of the rush of people who sell the stocks for profit and drastically increase the supply. After the lock-up period, insiders may sell the stocks.

ii) Waiting Periods

Initial waiting periods are often the part of offering terms of many investment banks. After a specific time, some shares are differentiated from others while purchasing. The price may increase or decrease depending upon if the allocation is bought by underwriters or not.

iii) Flipping

The practice of selling the stock in the initial days to earn a profit quickly is known as flipping. This method is commonly practised if the stock is discounted on the first trading day.

iv) Tracking Stocks

Tracking stocks are created when the company spins a part of its business as a standalone entity. In some situations, some parts of the company are separately more valuable than the company as a whole, and this is the only intention for sip-offs and tracking stocks creation. For example, if there is a fast-growing division with great potential, it is in a slow-growing company. Then the division can be taken out to raise capital from an IPO while the parent company may remain a large shareholder.

The investors see these as interesting IPO opportunities. Generally, spin-off provides information about the parent company to the investors. More information better it is for investors because investors may find good opportunities from such cases. As the investors are more aware, spin-offs can experience less volatility initially.

v) IPOs for a long term

Investors often earn from the IPOs and get benefits from the discounts, which attracts them to the company. Eventually, the price of the IPO will settle and become steady in the long term, and it follows traditional stock price metrics. Investors interested in IPOs but find the market risky may indulge in funds that are systematically managed. These provide benefits but are less beneficial when compared to direct stocks. Thus, investing must be studied before practice, which is possible through the study of appropriate resources.

Investing in an IPO

The decision of making the company public and offering IPO is taken by considering and analysing the proper strategy. This strategy is implemented to maximise the returns of the company and raises the capital of the company.

Many public investors start investing in shares for the first time when they know of the IPO decision of the company. The prospects of future growth increase with IPO. These are often discounted to increase sales so that the IPOs become attractive, especially when they have the generation of buyers from the primary issuance.

The initial price of the IPO is set through the pre-marketing process by the underwriters. Fundamental techniques are used for the setting of IPO price, and it is based on the fundamental techniques. Discounted cash flow is one of the most fundamental techniques, and IT is the net value of the company's future cash flow that is expected.

Per-share bases evaluation of the value is done by the interested investors and the underwriters. Comparable fund adjustments, enterprise value, equity value, etc., are the other methods that are used while setting the price. The underwriters sometimes discount the price to increase the demand on the day of IPO.

The analysis and understanding of the technology and basic knowledge of an IPO issuance are difficult. Generally, investors stay in touch with the news updates. However, the best way is to go through the prospectus released when the company goes for S-1 registration. The prospectus can provide almost all necessary data, but the investor must carefully focus on only important aspects. These include the management team, quality of underwriters, and deal specifics. Investment banks support successful IPO's and promote the issue well.

Hence, the entire process of IPO is a long way for a company. Therefore, interested investors must continuously go through the news headlines and stay informed about the price they could get for the share.

Purpose of an IPO

IPO is the process of selling shares of the company to the public to generate capital for the business for the first time. After an IPO stock exchange has the company name registered, and trading of shares can be done. The most important purpose behind the IPO is that to -

1. Raise capital from share sales.
2. Take higher valuation as an advantage
3. Provide liquidity to the early investors and the company founders.

Who can invest in an IPO?

Other investment options may be to invest in the mutual funds, these also focus on the IPOs. However, the returns are different for different investment options. Many a time, it is not necessary that the investor interested will be able to purchase shares according to his wish. However, some may participate in the IPO through the brokerage firm. This option is available only for the large clients of the firm in most cases.

Benefits of the IPO shares

IPO gains a lot of attention in the market. This attention is sometimes deliberately established by the company that is going public. Investors are interested in these companies as they earn money. Volatile price movements are produced by the IPOs, generally on the IPO day and after that. Hence these are quite popular among investors. However, it may produce losses, but generally, large gains are produced. Therefore, the ultimate solution is to know the company better by going through the prospectus of the company that is going public. Additionally, an investor must be well aware of all possible risks.