What is an IPO?
An initial public offering (IPO) is a process of offering shares of a private company to the public by listing its shares on a stock exchange for the first time. An IPO allows a startup to raise funds from public investors. Which also allows public investors to participate in the offering.
Why would a company want to go public? What Is the purpose of an IPO?
There are a few reasons for an Initial Public Offering, and the most obvious is gaining capital, as not every company can raise enough money from private investors. Besides that, going public can bring other benefits than just raising money. See some other reasons why companies go public below.
Reasons why companies go public:
- Money. Easy access to huge capital available from the masses is the main reason why companies prefer to offer shares through IPOs.
- Reputation. Getting listed in a reputable stock exchange adds credibility to a company - which comes in quite handy in a range of scenarios. The company is expected to be accountable to its many shareholders, and is therefore perceived as responsible.
- Publicity. An IPO helps obtain public sentiment towards the company. Going public in an IPO can provide companies with a huge amount of publicity.
- Taking profit. IPO offers an option to cash out for private investors who can sell their shares with profits or earn more by holding if shares gain in value.
- Financial benefits. It gives the company more power when negotiating new loan terms and interest rates on loans. With loans, listed companies can get capital at a lower rate of interest.
How does an IPO work?
For the IPO process, a private company contacts an investment bank (like JPMorgan Chase, Goldman Sachs, BofA Securities, Morgan Stanley etc) that will perform the IPO. The investment bank values the firm through financial analysis (due diligence), comes up with a valuation, define share price and a date for the IPO, and other information.
A business that plans an IPO must register with the exchanges and the Securities and Exchange Commission (SEC) to ensure it meets all criteria. Once all of the required processes are completed, a company will be listed on a stock exchange and its shares will be available for purchase and sale.
The IPO Process
Before listing an IPO, a company should go through an extensive IPO process, that includes steps described below:
Steps to an IPO:
- Choose an IPO underwriter. The issuing company selects a reputable investment bank to underwrite on the IPO.
- Pay the fees. Legal and accounting fees alone often start at $200,000 and can exceed half a million dollars. On the top of that, companies pay underwriter's 7 percent commission + marketing + other costs are added which can make the total cost for an IPO up to $25M.
- Conduct due diligence. Underwriters and legal counsel investigate the company with the goal of understanding any risks.
- Submit IPO regulatory filings. The IPO team compiles information that is required for IPO documentation, including: Letter of intent, Red Herring document, S-1 paperwork with the SEC
- Go on IPO roadshow. The issuing company and underwriters market the shares to institutional investors during the IPO roadshow in order to generate interest and estimate the demand for shares.
- Set the IPO price. After SEC approval, the IPO team finalizes the initial offer price and the amount of shares being issued based on: Investor demand, Company financials.
- Go public on the stock exchange. On the day of the IPO, the underwriter will release the initial shares to the public market.
- Use after-market stabilization tools. Following the IPO, underwriters have the ability to trade and influence pricing, but only for a so called quiet period. Stabilization strategies include the greenshoe option and lock-up periods.
- Begin transition to market competition. Once out of the quiet period, the company's stock is fully subjected to market conditions. The underwriter can evaluate the post-IPO valuation and earnings, but ultimately transitions to an advisor role.
How an IPO is priced?
Pricing an IPO is a bit of an art.
Underwriters (investment banks) considers numerous factors that can influence the IPO price like the current value of a company, as well as its future forecasts. Also, the IPO price incorporates the risk overview of the investment and compensates investors for such risk and potential supply and demand forces.
While IPOs are designed to give a premium to institutional investors taking a chance on a new stock, a big rally can leave investors wondering why shares weren’t priced higher. If the stock doesn’t pop, or worse if it falls companies can be viewed as failures for not attracting investors.
Underwriter balance IPO prices in a way that is high enough to raise sufficient capital for a company, while low enough to stimulate the interest of potential investors to purchase the shares. Maintaining the balance is critical to ensure the execution of a successful IPO.
For example, if an underwriter decides to set a very low offering price, a company will not be able to raise significant capital. Conversely, a high offering price may discourage potential investors from acquiring the issued shares.
What is an IPO lock-up period?
An initial public offering (IPO) lock-up period is a period of time after a company has gone public when shareholders are prohibited from selling their shares. During the IPO lock-up company, investors cannot sell their shares, helping to ensure an orderly IPO and more stable price. Lock-up periods usually last between 90 and 180 days. Once the lock-up period ends, most trading restrictions are removed.
Pros and Cons of an IPO: Should I Invest in IPOs?
For a regular investor, investing in an IPO is risky. After the stock is started trading publicly, oftentimes it dips down into negative territory. This is something that IPO investors should consider before participation. Moreover, IPO stocks have a tendency to swing strongly.
There’s a chance you’ll get major gains, that many people do. If a stock ends up excelling, early investors get the greatest reward. But because a company that wants to go public is seeking capital, they tend to start the IPO process when their performance is up.
Examples: Airbnb grew +115% on the first trading day, and Wish lost -90% of its value in a year.
One thing is obvious, you should always DYOR (Do Your Own Research) before participating in an IPO.
6 Tips to Check Before Investing in an IPO
- Check the business details. Sounds obvious, but just read the IPO description. If you don’t understand it - pass. It’s not you, it’s them who couldn't make things clear. Companies must be very straightforward about what their product/service is, the problem they are solving or the gap in the market they are filling and the way how they are going to earn money.
- Check the risks. The current market conditions, competitors (and their performance), quality of the product/service and possible regulatory changes. Company specific risks can be found in the IPO description.
- Check key people. Co-founders, CEO, CFO, CTO. Google directors and managers, one piece of negative press may be a misunderstanding, but many negative articles may be a red flag.
- Check the financial details. Financials are an important factor in the long-term success of the business. Many companies may be unprofitable yet when they go for an IPO, but the company should show at least strong continuous growth to deliver good results in the future.
- Check the valuation. If a company is overvalued at IPO, it may decline upon listing and so your investment may be better placed once the shares are trading. Compare the IPO valuation with the competitors that already traded publicly.
- Check the lead underwriter. IPOs with a well-known underwriter are often more reliable, because those investment banks tend to protect their reputation and choose wiser which companies they lead to an IPO.
What’s a prospectus, and why should IPO investors read it?
At IPObase we thoroughly read the prospectus for upcoming IPOs and include the key details in the IPO profiles.
An IPO Prospectus is an SEC required document that includes a description of the company and its operations, the terms and conditions of the initial stock offering, and any other information an investor may need to decide to invest.
This is the most important document the company and the investment bankers must produce to make an IPO happen is the prospectus. The prospectus lists all the opportunities, risks, and financial details about the company that's selling stock to the public. It's available to investors, regulators, and other interested parties. IPO prospectus includes:
- Risk factors
- Industry data and other metrics
- Financial data
- Management's discussion and analysis of financial condition
- Legal matters
IPO Alternatives - SPAC and DPO
SPAC stands for a Special Purpose Acquisition Company, which is a publicly traded company that has nothing (no operations, no assets, no profit or loss) — only cash and just one declared business plan to buy another company. SPACs are also known as "blank check companies".
Normally a SPAC is formed by a group of investors, called sponsors, with a reputation in a particular industry or business sector. They raise funds from other investors, and use the money to acquire an existing, privately held company — and then take it public in an IPO.
SPAC examples - Virgin Galactic, Palantir Technologies.
A direct public offering (DPO) is a type of offering in which a company offers its securities directly to the public to raise capital. Cutting out the intermediaries from a public offering substantially lowers the cost of capital of a DPO. Distinctive features of DPO:
- Shares start trading on an exchange with no previously issued shares.
- Everyone has access to the shares at the same time.
- The issuing company sets the terms according to its best interests.
DPO examples - Coinbase, Roblox.
How to Track Upcoming Initial Public Offerings (IPOs)
The most reliable sources of information on upcoming IPOs are stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ. If a company has not filed for IPO the information can be monitored through variety of financial analytical and news services like Bloomberg, Financial Times, Reuters etc. which may require to purchase a subscribtion.
Also you can subscribe to a free IPObase tracking tool, it monitors all the available reputable sources and notify you about upcoming IPOs and match with available IPO broker.
Steps how to buy an IPO stock
Here is the article from IPObase help center that explains how to buy an IPO stock.