The Basics of IPOs
IPO (Initial Public Offering) is the first sale of a stock that is made by a private company to the public. Often younger and smaller companies, who need capital to expand, issue IPOs. But a privately owned large company trying to become publicly traded can also issue them. The issuer, in an IPO, obtains assistance from an underwriting firm, which helps in determining what kind of security needs to be issued, along with the best offering price and the right time to bring it into the market. It can be very risky to invest in IPOs. Predictions related to the stock are not easy to make for an individual investor. It is difficult to forecast what the stocks will do on the initial trading day and in the future, since there is little data with which a company can be analyzed. Most of the IPOs are of companies that are going through a transitory growth phase, and so they are subject to certain uncertainties regarding their value in the future.
IPO is a term that became popular during the tech bull market of the 1990s. Companies can raise money by issuing equity or debt, and if a company has never issued equity to the public, then it is known as an IPO. It might be difficult to get an IPO but not impossible. Underwriting is a process through which an IPO is done. Hiring an investment bank is the first thing that is done by a company when it wants to go public. It can sell shares on its own theoretically, but realistically, it requires an investment bank. Through underwriting, money is raised by equity or debt. Underwriters can be considered as middlemen between the investing public and the companies.
The investment bank and the company will first meet and negotiate the deal. The items that are discussed usually are related to the amount of money a company will be raising, the type of securities that will be issued, and other details in the underwriting agreement. There are various ways a deal can be structured. For instance, in a form commitment, the underwriter will guarantee a certain amount raised by purchasing the entire offer, and then selling it again to the public.
Once each party agrees to the deal, a registration statement is put together by the investment bank, to be filed with the SEC. The registration statement contains information about the offering, and the details of the company like the management background, financial statements, legal problems if any, and insider holdings. Then a cooling off period is required by the SEC, in which investigation is conducted to make sure that all the material information has been disclosed. Once the SEC approves the offering, a date is set for offering that stock to the public.
The underwriter puts together a red herring during the cooling off period. This is an initial prospectus that contains all the information about the company except the effective date and offer price. The company and the underwriter attempt to hype and build up interest for the issue with the red herring in hand. With the effective date approaching, the company and underwriter get together to decide on the price. This is not an easy decision to make, and depends on the company, along with the current market conditions. Finally, the securities are sold in the stock market and money gets collected from the investors. The road to an IPO is a long and complicated one, so you need to take the steps carefully.