Initial public offering
An initial public offering or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail investors. An IPO is typically underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company. IPOs can be used to raise new equity capital for companies, to monetize the investments of private shareholders such as company founders or private equity investors, and to enable easy trading of existing holdings or future capital raising by becoming publicly traded.
After the IPO, shares are traded freely in the open market at what is known as the free float. Stock exchanges stipulate a minimum free float both in absolute terms and as a proportion of the total share capital. Although IPO offers many benefits, there are also significant costs involved, chiefly those associated with the process such as banking and legal fees, and the ongoing requirement to disclose important and sometimes sensitive information.
Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertake an IPO with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide several services, including help with correctly assessing the value of shares and establishing a public market for shares. Alternative methods such as the Dutch auction have also been explored and applied for several IPOs.
History
The earliest form of a company which issued public shares was the case of the publicani during the Roman Republic, although this claim is not shared by all modern scholars. Like modern joint-stock companies, the publicani were legal bodies independent of their members whose ownership was divided into shares, or parts. There is evidence that these shares were sold to public investors and traded in a type of over-the-counter market in the Forum, near the Temple of Castor and Pollux. The shares fluctuated in value, encouraging the activity of speculators, or quaestors. Mere evidence remains of the prices for which parts were sold, the nature of initial public offerings, or a description of stock market behavior. Publicani lost favor with the fall of the Republic and the rise of the Empire.In the United States, the first IPO was the public offering of Bank of North America around 1783.
Procedure
IPO procedures are governed by different laws in different countries. In the United States, IPOs are regulated by the United States Securities and Exchange Commission under the Securities Act of 1933. In the United Kingdom, the UK Listing Authority reviews and approves prospectuses and operates the listing regime.Planning
Planning is crucial to a successful IPO. Following highlights some general steps to planning :- develop impressive management and professional team
- grow the company's business with an eye to the public marketplace
- obtain audited financial statements using IPO-accepted accounting principles
- clean up the company's act
- establish antitakeover defenses
- develop good corporate governance
- create insider bail-out opportunities and take advantage of IPO windows.
Retention of underwriters
A large IPO is usually underwritten by a "syndicate" of investment banks, the largest of which take the position of "lead underwriter". Upon selling the shares, the underwriters retain a portion of the proceeds as their fee. This fee is called an underwriting spread. The spread is calculated as a discount from the price of the shares sold. Components of an underwriting spread in an initial public offering typically include the following : manager's fee, underwriting fee—earned by members of the syndicate, and the concession—earned by the broker-dealer selling the shares. The manager would be entitled to the entire underwriting spread. A member of the syndicate is entitled to the underwriting fee and the concession. A broker-dealer who is not a member of the syndicate but sells shares would receive only the concession, while the member of the syndicate who provided the shares to that broker-dealer would retain the underwriting fee. Usually, the managing/lead underwriter, also known as the bookrunner, typically the underwriter selling the largest proportions of the IPO, takes the highest portion of the gross spread, up to 8% in some cases.
Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the major selling syndicate in its domestic market, Europe, in addition to separate group corporations or selling them for US/Canada and Asia. Usually, the lead underwriter in the head selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements and because it is an expensive process, IPOs also typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and the white-shoe firms of New York City.
Financial historians Richard Sylla and Robert E. Wright have shown that before 1860 most early U.S. corporations sold shares in themselves directly to the public without the aid of intermediaries like investment banks. The direct public offering, as they term it, was not done by auction but rather at a share price set by the issuing corporation. In this sense, it is the same as the fixed price public offers that were the traditional IPO method in most non-US countries in the early 1990s. The DPO eliminated the agency problem associated with offerings intermediated by investment banks.
Allocation and pricing
The sale of shares in an IPO may take several forms. Common methods include:- Best efforts contract
- Firm commitment contract
- All-or-none contract
- Bought deal
The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under a specific circumstance known as the greenshoe or overallotment option. This option is always exercised when the offering is considered a "hot" issue, by virtue of being oversubscribed.
In the US, clients are given a preliminary prospectus, known as a red herring prospectus, during the initial quiet period. The red herring prospectus is so named because of a bold red warning statement printed on its front cover. The warning states that the offering information is incomplete, and may be changed. The actual wording can vary, although most roughly follow the format exhibited on the Facebook IPO red herring. During the quiet period, the shares cannot be offered for sale. Brokers can, however, take indications of interest from their clients. At the time of the stock launch, after the Registration Statement has become effective, indications of interest can be converted to buy orders, at the discretion of the buyer. Sales can only be made through a final prospectus cleared by the Securities and Exchange Commission.
The final step in preparing and filing the final IPO prospectus is for the issuer to retain one of the major financial "printers", who print the registration statement on Form S-1. Typically, preparation of the final prospectus is actually performed at the printer, wherein one of their multiple conference rooms the issuer, issuer's counsel, underwriter's counsel, the lead underwriter, and the issuer's accountants/auditors make final edits and proofreading, concluding with the filing of the final prospectus by the financial printer with the Securities and Exchange Commission.
Before legal actions initiated by New York Attorney General Eliot Spitzer, which later became known as the Global Settlement enforcement agreement, some large investment firms had initiated favorable research coverage of companies in an effort to aid corporate finance departments and retail divisions engaged in the marketing of new issues. The central issue in that enforcement agreement had been judged in court previously. It involved the conflict of interest between the investment banking and analysis departments of ten of the largest investment firms in the United States. The investment firms involved in the settlement had all engaged in actions and practices that had allowed the inappropriate influence of their research analysts by their investment bankers seeking lucrative fees. A typical violation addressed by the settlement was the case of CSFB and Salomon Smith Barney, which were alleged to have engaged in the inappropriate spinning of "hot" IPOs and issued fraudulent research reports in violation of various sections within the Securities Exchange Act of 1934.
Pricing
A company planning an IPO typically appoints a lead manager, known as a bookrunner, to help it arrive at an appropriate price at which the shares should be offered. There are two primary ways in which the price of an IPO can be determined. Either the company, with the help of its lead managers, fixes a price, or the price can be determined through analysis of confidential investor demand data compiled by the bookrunner.Historically, many IPOs have been underpriced. The effect of underpricing an IPO is to generate additional interest in the stock and a rapid rise in share price when it first becomes publicly traded. Flipping, or quickly selling shares for a profit, can lead to significant gains for investors who were allocated shares of the IPO at the offering price. However, underpricing an IPO results in lost potential capital for the issuer. One extreme example is theglobe.com IPO which helped fuel the IPO "mania" of the late 1990s internet era. Underwritten by Bear Stearns on 13 November 1998, the IPO was priced at $9 per share. The share price quickly increased 1,000% on the opening day of trading, to a high of $97. Selling pressure from institutional flipping eventually drove the stock back down, and it closed the day at $63. Although the company did raise about $30 million from the offering, it is estimated that with the level of demand for the offering and the volume of trading that took place they might have left upwards of $200 million on the table.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, the stock may fall in value on the first day of trading. If so, the stock may lose its marketability and hence even more of its value. This could result in losses for investors, many of whom being the most favored clients of the underwriters. Perhaps the best-known example of this is the Facebook IPO in 2012.
Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock but high enough to raise an adequate amount of capital for the company. When pricing an IPO, underwriters use a variety of key performance indicators and non-GAAP measures. The process of determining an optimal price usually involves the underwriters arranging share purchase commitments from leading institutional investors.
Some researchers believe that the underpricing of IPOs is less a deliberate act on the part of issuers and/or underwriters, and more the result of an over-reaction on the part of investors. One potential method for determining to underprice is through the use of IPO underpricing algorithms. Other researchers have discovered that firms with higher revenues from licensing-based technology commercialization exhibit greater IPO underpricing, while a firm's stock of patents mitigates this effect.