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In a typical day on Wall Street, the markets are buzzing with news on the latest, hottest initial public offering, otherwise known as an IPO. Everyone seems to be talking about the next billion-dollar company that is about to go “public”. So what is an IPO? And is it really a way to strike it rich?
What is an IPO?
To explain the intricacies of an IPO, let's look at what it is from two points of view: from the shareholder's perspective and the company's perspective.
What is An IPO From the Shareholder’s Perspective
An IPO is an “initial public offering,” which marks the transition of a private company to a public company by opening up the sale of a company’s stock on one or more public stock exchange.
IPO’s describe the first days where a company’s stock can be sold to the public, providing the opportunity for millions of investors to buy shares of the company.
After an IPO, shares are traded freely in the open market.
What is An IPO From the Company’s Perspective
As a private company’s business grows and begins to gain traction, the largest shareholders of that company may begin considering an IPO.
The large shareholders may wish to liquidate their holdings or “cash-out”, the company may need access to additional financing, or the company may want to use the cash raised to grow quickly.
An IPO is a corporate action that could further the goal of liquidation and produce significant cash.
A large number of IPOs are usually a sign that there is a bull market, meaning that the economy is doing well. During a bear market, when prices are dropping, which encourages selling, expect to see very few IPOs.
For example, in 2008 (during the first year of the Great Recession) there was a record low number of IPOs.
Now that we’ve explained what is an IPO, it’s time to explore the IPO process.
A privately-held company (the “issuer”) needs to go through multiple steps to become eligible to sell its securities on a recognized stock exchange.
The process to go public can last anywhere from six to twelve months.
The steps are as follows:
Select Lead Investment Bank
The first step during the IPO process is for the issuer to select an investment bank to assist them going public.
The investment banker’s role is to find investors that are interested in buying the stock when it goes public. The members of the bank travel across the country during a “roadshow”, meeting with investors to generate excitement about the IPO and gauge interest.
The investment bank is tasked with valuing the company and setting the initial stock price.
The issuer will meet with a number of prospective investment banks to decide on who they want to work with. The banks compete to pitch their investment banking services in what is known as a “bake-off”.
When the issuer chooses an investment bank, this is known as “awarding the mandate”. For larger IPOs, the lead investment banker is known as the “bookrunner” and may partner together with other investment banks to form a “syndicate” to assist them in finding a wide array of investors. Make sense?
Due Diligence and Regulatory Filings
The second step occurs 3 months before the IPO.
In the due diligence and regulatory filings stage, the IPO team prepares the following:
- Marketing materials
- S-1 Registration: Required by the SEC, this contains key information about the issuing company, including financial and ownership details. It also includes a management description, business risks and competition, corporate governance, and executive compensation.
- Prospectus: This contains a summary of the company’s financial statements.
The SEC will examine the registration documents to ensure the issuer’s information is correct and all financial data is disclosed.
Once the SEC declares the registration effective, the issuer is legally able to sell shares, and works with the SEC to set an IPO date.
Book Building and Marketing
While the SEC is reviewing the filings, the bankers determine market interest for new shares. The lead bankers conduct a roadshow and market the deal toward institutional investors.
Stirring up interest among large institutions is critical to the success of any IPO and is known as “book building”.
Pricing and Sale to Investors
Investment banks determine the initial stock price based on investor demand. The initial price is usually expressed as a range (i.e. $22.0 – $25.0 per share) — not a binding range and can change based on market demand.
If demand for shares is strong, the price range can be raised.
If, on the other hand, demand for shares is weak (also known as a cold offering), this can cause the price range to drop.
The issuer can also increase the number of shares sold prior to the effective date (known as upsizing the deal).
The lead investment banker makes sure that enough investors want to purchase shares and determines how to allocate the number of shares between interested investors.
Investors interested in buying the issuers stock place bids or “indications of interest” — (IOIs) — indicating the price they would pay per share and how many shares they would like to buy.
The investment bank will confirm the IOIs with clients and sell the newly registered shares to institutional investors on the first day of trading.
The initial sale to these investors is on the “primary market” and the stock is not yet open to other investors.
On the second day of trading, the new shares are priced and the first trades occur on major stock exchanges such as the NYSE and Nasdaq.
This is known as the “secondary market” and is when most individual investors can begin buying the stock.
Advantages of a Company’s IPO
After understanding what is an IPO and it’s process, the next step is to look at the advantages for a company.
Companies tend to go public when market conditions are favorable — indicated by strong investor demand and a stable stock market.
IPOs are an impressive milestone for most companies.
When shares begin to trade on major exchanges like the NYSE, newly public companies join an exclusive league comprised the most famous and influential companies in the world.
While status is a perk of going public, there are many other advantages of an IPO:
- It provides a liquidity event, allowing founders, equity holders, and early investors to sell their shares and monetize investments.
- It creates a meaningful, broad valuation of the company by exposing stocks to a large pool of investors.
- The company raises cash to fund its needs such as paying off debt and buying assets. Successful IPOs drive growth and provide access to cheaper capital.
- IPOs introduce a large number of investors, which broadens interest and can improve the reputation of the company.
- Public stock can be used to provide benefits such as stock options, employee ownership plans, and retirement contributions to incentivize executives and employees to work at the company.
Disadvantages of a Company’s IPO
While IPOs provide many benefits, there are also tradeoffs associated with going public.
- Management loses some control of the company in exchange for additional funding. Thus, more power is given to the shareholders and the board of directors to make important business decisions.
- Paying for an IPO is expensive — investment banks charge a hefty fee, taking a percentage of the price per share.
- Once public, companies need to spend more money on auditors, financial reporting teams, and a legal counsel to adhere to the hefty reporting requirements.
- The company is under greater public scrutiny — the SEC has strict regulatory reporting requirements.
- Public companies are at increased risk of litigation, such as class action lawsuits and shareholder actions.
An IPO Case Study: Facebook
One of the most famous IPOs of the 21st century is when Facebook went public in 2012. At the time of the IPO, it was one of the largest in technology and internet history.
With a rapid increase in the number of users and the popularity of founder Mark Zuckerberg, the IPO was highly anticipated. After all, Facebook had over 500 shareholders, receiving a lot of pressure to go public.
Facebook was reluctant to do so. They were in no rush and the executives wanted to maintain a significant amount of ownership. Leading up to the IPO, Facebook turned down offers from tech giants Viacom and Yahoo to buy the company.
But, they eventually began the process. As Morgan Stanley, the lead investment bank, went on the roadshow to market the Facebook IPO, the initial share price was estimated at $28 to $35 per share. After gauging market interest, the target price was raised to $34 to $38 per share.
Due to very strong investor demand, on the day before the IPO, the stock price was locked in at $38 per share, or a valuation of $104 billion.
On the first day of trading the stock price was volatile and fluctuated for a few weeks after. Many investment analysts thought the company was overvalued, and ultimately the initial reaction to the IPO was one of disappointment.
By August 2012, the share price dropped to $20 per share.
The effects of Facebook going public led to some significant changes in the company.
A few of Facebook’s top shareholders became billionaires overnight and Mark Zuckerberg still retained 22% ownership of the company and 57% of the voting shares.
A crowded investor-base and a high valuation made investing in Facebook less attractive for the next few years. However, Facebook received significant capital to continue its explosive growth, reaching one billion users shortly after the IPO.
Facebook was immediately introduced to increased regulatory scrutiny.
There were over 40 lawsuits filed during the first month after the IPO due to faulty reporting of earnings by Morgan Stanley.
The SEC launched investigations into Facebook due to sharp price declines in the first days of trading.
As with most IPOs, there were both pros and cons to Facebook going public.
Facebook will go down as one of Wall Street’s most famous IPOs.
Since then, IPOs have become increasingly popular and are frequently in the public spotlight.
Investing in IPOs
2019 has been an exciting year in the world of IPOs. Famous companies like Uber, Lyft, and Pinterest have recently gone public.
It can be tempting for investors to want to buy the stocks of these revolutionary companies and get in at the “ground floor”.
The question is, are investors buying the stocks because they are caught up in the IPO-hype or because they are good investments?
There have been many IPO success stories: Amazon, Google, and Microsoft all had very successful IPOs. But for every winner like Microsoft, there are hundreds of losers.
While investors may think they’re getting a jump on investing in a company earlier than others, remember that many institutional investors purchased the stock most likely at a cheaper price the day before.
High returns on IPOs are captured by members of the exclusive club — investment bankers and other institutional investors get shares at the initial price — before the stock begins public trading. Many IPOs of well-known companies are over-hyped and investors pay artificially high prices for newly issued stocks due to demand.
IPOs can sound like a great idea in therogy, but tend to underperform for several years after being issued.
Many people see the rapid price increases of IPOs in the short-term and are excited by the opportunity of quick profits.
In the long-term, these profits can quickly transform to large losses.
For example, in March 2017, Snap Inc, the parent company of Snapchat, went public. Its stock price rose 40% in the first day of trading.
However, while Snapchat’s IPO price was $17, it dropped to a low of $5 at the end of 2018.
Finance journalist Jason Zweig, accurately summed of the disadvantages of investing in IPOs with his explanation of what “IPO” actually stands for:
How to Buy an IPO
There are circumstances where investing an IPO is profitable. In order to make money off an IPO, investors should proceed with caution and do plenty of research before investing.
The best way to avoid the IPO-hype is by focusing on the fundamentals of the company.
The famous investor Benjamin Graham emphasized that “no matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.”
If an investor decides to invest in a new public company, it is risky to buy all of a position on the first day of the IPO.
Using dollar cost averaging, investors could maximize returns by spreading out the investment over time with periodic payments.
MarketWatch.com provides valuable information and dates of upcoming IPOs. Exchanges like NYSE and Nasdaq also post calendars of IPOs.
Soon after the IPO takes place, the stock will be available on an exchange and open to public investors.
Invest in Long Term Value
Know that you know what is an IPO, it’s important to ask yourself this: Is it important to be the first in line?
Avoid jumping on the bandwagon and buying an IPO because it’s the hot new stock.