IPO or Initial Public Offering refers to the process of a company going public, in order to sell shares of its business to outside investors. This usually happens on a well-established stock exchange, such as NASDAQ or the New York Stock Exchange. Investors can then become a part-owner of the business by purchasing those listed shares. Thus, an IPO marks the transition of a company from private to publicly owned.
Launching an IPO requires a company to make a plethora of changes such as allowing shareholders to vote on business decisions such as the appointment of its board of directors, as well as issuing all financial reports to the public on a quarterly and annual basis. From an investor’s point of view, Initial Public offerings can be considered as a lucrative opportunity to invest in a small stake in a company whose value is expected to appreciate.
It should be noted however that some well-known successful stocks in the world have initially struggled for months before they appreciated in value, sometimes even years after their IPOs. A glaring example would be Facebook, which took more than a year to trade above its IPO price after going public in 2012.
Five Biggest IPOs in History
Saudi Aramco (2019): $30 billion (Inflation-Adjusted)
The Alibaba Group (2014): $27 billion (Inflation-Adjusted)
SoftBank Group (2018): $24 billion (Inflation-Adjusted)
Agricultural Bank of China (2010): $26 billion (Inflation-Adjusted)
Industrial and Commercial Bank of China (2006): $28 billion (Inflation-Adjusted)
There are many reasons why companies go for Initial Public Offerings. Through an IPO, a company gets a legitimate and easy way to raise a lot of funds. The money from the sale of shares can be used to pay down the debts a company might have, fund projects, or expand business operations. They are also required to provide increased transparency.
For a company, opening up on the public market increases the chances of attracting millions of investors, who buy shares and contribute capital to the shareholder’s equity. Generally, the newer shareholder’s equity value is determined by the overall number of shares sold and the price of each.
The IPO Process: Step by Step
When a company converts to a public entity, its shares are priced through underwriting due diligence. The previously owned private ownership of shares are converted to public ownership. The process of share underwriting involves special provisions for converting private-owned shares to public. Private investors can cash in at this time and earn their expected returns.
The process of undergoing an Initial Public Offering can be categorized into two parts, namely, the pre-marketing phase and the Initial public offering phase. When a company decides to go for an IPO, it can either make a public statement to generate interest in the market or advertise separately to underwriters. This is done by soliciting private bids. Underwriters, usually the major investment banks, are the main entity that can initiate and lead the IPO process. Companies are required to choose the underwriter themselves. They can even choose several underwriters for a collaborative effort in managing the different parts of the IPO. Underwriters are usually involved in almost every aspect of the Initial Public Offering, such as filing, marketing, document preparation, due diligence, issuance, etc.
Below, a step by step explanation of the whole IPO process is provided
The first step involves the underwriters presenting their proposals and valuations. They suggest the offering price, the number of shares to be offered, the best type of security to offer, and the estimated time frame for the offering.
The company then chooses its desired underwriters and signs an underwriting agreement to formally agree to the underwriting terms.
A team is formed for the IPO process, consisting of lawyers, underwriters, Securities and Exchange Commission experts, and certified public accountants.
To prepare for the required IPO documentation, the team compiles critical information regarding the company.
The S-1 Registration statement forms the core of the initial IPO filing document, consisting of two parts, the privately held filing information, and the prospectus. This form includes information about the expected date of the filing, which is revised throughout the pre-IPO process. The prospectus is also revised frequently.
Pre-marketing and roadshow of the new stock issuance involves the creation of marketing materials. This is usually divided into two parts
The share issuance is marketed by both underwriters and executives after which a final offering price is established. Underwriters usually conduct financial analysis throughout the whole marketing process which is subject to revision. They can even revise the IPO price or its issuance date, depending on circumstances.
There are several public share offering requirements that the company has to fulfil and thus, necessary steps are taken. Each public company must adhere to SEC requirements regarding public companies as well as individual exchange listing requirements.
A board of directors is then formed.
The company then ensures streamlined processes for reporting auditable accounting and financial information on a quarterly basis.
The shares of the company are issued on a pre-fixed IPO date. Here, the company receives funds through the primary issuance of shares to the public. The funds received should be recorded as stockholder’s equity on the company’s balance sheet. From that moment onwards, the stockholder’s equity per share valuation determines the balance sheet share value.
In the final step, companies may be required to institute some post IPO provisions. Certain investors may be restricted to a cold period where they cannot be involved in any informal or formal business discussions. Underwriters are also allotted a specified time frame under which they can buy additional shares even after the IPO date.
IPO – how to invest
What is an IPO prospectus (S-1 form)?
Before we go any further, we should first be aware of the S-1 form. The SEC Form S-1 is an initial registration form required by the Securities and Exchange Commission in the United States for all listed public companies. Companies usually have to file an S-1 filing before their shares can be listed on any of the country’s national exchanges, such as NYSE. The first part of the form is known commonly as the prospectus. It fills out the information on the use of proceeds, the financial condition of the company, detailed business operations, key management personalities, the price per offered share, the percentage of the company being sold by individual holders, and who are the underwriters. Filed by companies who have decided to list on the market with an Initial Public Offering it happens to be the main document to analyze before investing in IPO.
The shares of the newly announced public company would be available to buy after the pricing details and the IPO date has been finalized. However, for that, investors would need to open a brokerage account. There are several brokerages that operate currently in the market. For an investor, he/she should choose a brokerage provider after evaluating several factors such as minimum account deposits, fees, educational resources provided, trading commissions, and level of customer support.
IPO day 1 trading
Difference between the offering price and price of the stock
Before one starts to invest in an IPO, however, they need to be aware of a distinction. There is a big difference between the offering price of an IPO and the price of the stock. The offering price refers to a fixed price that is announced ahead of the IPO event. It is reserved for a limited group of investors which includes the employees and investors of the company that satisfies certain criteria. The criteria can include how frequently one trades and minimum asset balance.
The investors and employees belonging to the above group have their orders filled before the IPO officially begins. For the general public, the IPO share price is usually lower than the price predicted by analysts on the open market.
Day trading an IPO stock on day 1 can be a very risky affair in spite of carrying the potential for reaping huge rewards. One of the major things that make an IPO enticing is the fact that its prices are volatile. Another huge advantage for investors who qualified for the offering price can profit immensely as the IPO price is way higher.
One should, however, remember that traders cannot short IPOs. Traders are required to aggressively manage their risk, meaning that they cannot get stubborn with their positions.
Investing in IPO: pros and cons
Despite what many say, there are many advantages when trading with IPOs including many long term possibilities. However, there are several disadvantages as well.
Long term possibilities
High stock pricing
Allows investors to discover and invest in new emerging companies that may appreciate in value
Investors are always at risk of competitors with huge cash piles. They more often than not get an advantage over other investors
In conclusion, investing in IPOs have a lot of profit potential, but carries some inherent risks with it as well. Risk management is always a key part of IPO trading and investors should always be cautious and examine everything with skepticism. After conducting some objective research, investors should always tend to pick a company with a strong investment firm as an underwriter. They should not forget to read the prospectus and avoid companies that project an overly optimistic future earnings outlook.