Business & Management

A Guide to Initial Public Offerings | How Does an IPO Work?

What is an IPO?

When a private company first sells shares to the public, this process is known as the initial public offering ( IPO). In essence, IPO means that the ownership of a company is transitioning from private ownership to public ownership. That is why the IPO process is sometimes referred to as “going public.”

Why do companies want to go public?

Companies want to go public for various reasons, depending on their circumstances. Most seek to raise capital to fund expansion, pay debts, attract and retain talent, or monetize assets. A company may also want to be listed on a stock exchange in order to improve its public profile.

Start-up companies or companies that have been in business for decades may decide to go public through an IPO. Companies typically issue an IPO to raise capital to pay off debts, fund growth initiatives, raise their public profile or allow insiders to diversify their holdings or create liquidity by selling all or part of their private shares as part of the IPO.

In addition, the potential of a future IPO is one of the major incentives that fledgling firms use to attract initial investors. By selling their holdings, existing shareholders in the firm can recover their value from a successful public offering. The potential for this windfall makes it possible for young firms to attract the capital they need to operate while still small and private, and rewards directors and early employees for taking risks to an unproven firm.

How an IPO Works?

An initial public offering is a process of structuring the shares of the company for sale, establishing stakeholders, and establishing regulatory compliance, which focuses mainly on financial disclosure and transparency. Most of this process is designed to protect the general public from buying shares in fraudulent companies.

The IPO process begins when a company decides that it wants to sell its shares to the public through a stock exchange. First, an audit must be carried out – taking into account all aspects of the company ‘s finances.

The company hires a third-party accounting firm to conduct a complete audit of its finances.

The company, with the help of its underwriter, shall assemble SEC registration documents. These include a prospectus that is circulated to all potential investors and private filings which are for the eyes of the SEC only. The registration documents shall include detailed financial information (including audits by the third party), information on the management of the company, its potential liabilities, the ownership of private shares, and its business plan.

The SEC exercises due diligence to ensure that all information contained in the registration documents is accurate and complete.

If everything is in order, the company must prepare a registration statement to file with the appropriate exchange commission, such as the SEC. Next, the stock exchange examines the application, after which it is either accepted – sometimes subject to certain amendments – or rejected. If approved, the company will list a defined number of shares and will be available for sale through the chosen stock exchange.

Well-managed IPOs could take up to 12 months, but they could be longer.

Who sets the IPO price?

Investment banks have set the IPO price. The company decides how many of its shares it wants to sell to the public, and then the nominated investment bank evaluates the company. Once this is done, the initial share price will be released and the public can start trading shares when the listing takes place.

IPO Success Stories

Sometimes the IPO is very successful, but this is not determined by what happens on the first day or even in the first year. In order to have a really successful IPO, we need to look much longer term.

Facebook

The social networking firm has been the first big tech IPO since Google, and the hoopla surrounding its public exchange debut echoed the dot-com boom hysteria of the 1990s.

Originally Facebook filed for an IPO selling its shares at $28 to $35. Then, due to strong demand, it filed to sell 25 percent more shares. It had raised the target range to $34 to $38 per share two days before its IPO. According to many analysts, this was a sign of pure irrationality.

The stock eventually opened at $42 per share for trading, 50% higher than the bottom of its earlier range.

The Facebook share price has reached $230 in 2020.

Pros and Cons of Going Public

There are advantages and disadvantages that arise when a company goes public.

Pros of IPO

1.Capital: The IPO is a good way for the company to raise capital. In the IPO, the company sells shares to IPO investors and receives cash and a lot of cash.
2.Acquisition Currency: Once it is public, the company can acquire other companies and use its stock as an acquisition currency instead of cash (or cash and stock). This means that the company can grow through acquisition (called inorganic growth) without using its cash.
3.Liquidity: The IPO could provide liquidity (in this case, the ability to sell shares in the public market) to the founders, employees, or pre-IPO investors of the company. If a company has venture capital or private equity investors, the IPO will provide an investor with the opportunity to sell its shares. Note that it is common for founders, employees and pre-IPO investors to be restricted from selling their shares on the open market for 6 months after the IPO as a way to help stabilize the stock price after the IPO.
4.Reputation: The IPO can enhance the reputation and credibility of the company. The customer may be more willing to try the product or the vendor may be more willing to extend the credit terms if the company is public. Also, once it is public, the company will be covered by the financial press, so that the company will be more in the public eye.
5. Recruiting Benefits: Being able to provide employees with equity (through stock options or restricted stock grants) is a valuable benefit for employees. Some employees may prefer to work for a public company, as the company is perceived to be stronger than a private company.

Cons of IPO

1.Short-term focus: Since public companies are required to file quarterly and annual reports, there is concern that public sector management focuses on short-term performance. This is due to the fact that management usually receives a good portion of its compensation as equity. This gives management an incentive to increase the stock price, and the way to do this in the short term is to focus on maximizing short-term results.
2.Public company costs: It is expensive to be a public company. The cost of an IPO is high, and the cost of ongoing legal and financial reporting can be expensive. For bigger companies, we are talking about over a million dollars a year.
3.Public reporting requirements: Once it is public, the company must report publicly on its operations and finances. These reporting requirements can be very burdensome (especially for the CFO, but also for the CEO), and the company lives under a microscope. If the company is doing well, the market will love the company. If the company does not do that well, the market may react brutally to the underperformance of the company. Staying private means you can operate outside the eyes of the public. That’s why some public companies go private (such as in a buyout) – so that they can restructure the company’s strategies and/or private operations, and then, when the company is doing well operationally, go public again.
4.Competitor information: In order to make the company public, the company discloses a lot of information about the company – its market, its customers, its strategies, its competition, its operations, and also its finances. This information may be of great value to its competitors.
5.Short-Sellers: Short sellers are investors who believe that the stock of the company is overpriced and that the stock is going to fall. These investors enter into contracts to sell the shares of a company’s stock if they do not actually own the shares. When the stock price falls, these short sellers buy the stock to fill their orders and collect a profit roughly equal to the sale price, less than what they bought the stock.

See Also
What is Venture Capital?
What is an LLC Company?

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