Understanding Initial Public Offering (IPO)
What is an initial public offer?
A company can raise funds from the primary market by selling securities to the public. It helps the company grow and expand. In doing so, a private company goes public. This is known as an Initial Public Offering or IPO.
The process of going for an IPO is extensive and detailed. It takes about 16-20 weeks for a company to go from planning an IPO to getting listed on the stock exchange. Once listed, the stock is available for trading in the secondary market.
Types of Initial Public Offerings
There are two types of Initial Public Offerings. A fixed price issue and a book building issue.
In fixed price issues, the offer price and allotment of the securities is known beforehand to investors. The demand for the securities is known after the issue closure. Payment is made during the subscription. A refund, if any, is provided after allocation.
In book-building issues, issuers offer a price band of 20%. Investors are allowed to bid within this band and the final price is determined by the issuer after the bid closure. Payment is made after allocation. The demand is known as the bidding occurs.
What happens before the IPO?
The period before the IPO is known as pre-filing. First, all key members of the IPO working committee have a meeting. Here, the timing of the issue, tasks and responsibilities are discussed.
The underwriters or investment banks that will manage the IPO, then use prospective investor interest to suggest a share price to the issuer. Due diligence of documents and company details is undertaken. Finance, accounting and operations are some of the areas under this ambit. Legal documentation of the underwriting agreement, lock-up agreements, legal opinions, and press releases about the price, and date of issue are completed. Then the venue of listing, such as the New York Stock Exchange NYSE or another exchange is fixed.
In addition to these, valuation updates, continued due diligence, equity research analyst briefings, internal approvals from underwriters, and submission of documents to the U.S. Securities and Exchange Commission (SEC) occur.
Then the filings are done with the SEC.
During the wait time, when the SEC reviews and evaluates the filings the underwriters continue to work on the roadshow presentation and marketing strategy. This could also include talks with investor groups to better understand their criteria for investing.
The market demand for the shares and the potential revenue that the company can make from the sale of the shares are used to value the shares for an initial public offering (IPO). This is usually accomplished through a procedure known as underwriting, in which a number of investment banks evaluate the firm's financial performance, the potential for growth, market trends, and other elements to establish the proper share price. In order to determine investor interest, the underwriters will then perform market research. Based on their findings, they will determine the first share price for the company.
On receiving comments if any from the SEC, required changes are made. These amended documents are sent for review, till the papers are finally approved for registration. Discussions on price, marketing strategy, roadshow preparation and offering structure are conducted.
In the 15th week focus shifts to marketing and conducting the roadshow across chosen cities.
Initial Public Offer Process
- Companies file a registration statement using form S-1 to register their initial public offering with the SEC.
- A prospectus or an offer document that will be given to investors must also be submitted to the SEC. It offers information about the company and details about the IPO. The terms of the securities, the company’s financial conditions, management, and disclosures are all available in the prospectus.
- The SEC reviews and in some cases states the details of the prospectus that must be changed to better reflect the company’s reality.
- Investors can participate in the Initial Public Offering either through the underwriter or directly. Usually, underwriters and dealers distribute most of the shares to institutional and high net-worth customers. These include mutual funds, hedge funds, insurance companies, and pension funds.
- Individual investors can also buy shares when they are resold in the public market.
What is an oversubscribed or undersubscribed IPO?
Oversubscribed: The number of available shares of a company is less than the number of shares investors want. This implies that investors are keen to buy the stock and might be willing to do so at higher than issued prices. In this case, companies can offer more securities or raise their price. Sometimes they choose to do a mix of both.
Undersubscribed: The number of available shares of a company is more than the number of shares investors want. It indicates poor pricing, poor marketing to investors, or that investors do not see value in the company.
Considerations for Investors
Investors can search for company information at SEC’s EDGAR database. This can be done 20 days after IPO registration at SEC and the registration is considered effective.
Read the company’s IPO prospectus thoroughly. Check if the details are current. The prospectus contains a summary, risk factors, use of proceeds, dividend policy, dilution (the difference in price that investors pay for the shares in comparison to the book value of the shares and the price paid by existing shareholders), key financial data and declarations, discussion and analysis by management, lines of business, biographies of management and financial notes.
Offering price by the company should be determined by market conditions, analysis and valuation. Investors have to assess if the offer price is too high or if is it a fair bargain. Investors should remember that the offer price and the trading price of the securities may differ and have no real relation.
Investors should pay attention to selling shareholders who will keep the money they get from selling their shares through the IPO. This information is available under Principal and Selling Shareholders.
Investors need to observe the Market Overhang, which is outstanding shares that cannot be traded at the time of the IPO. On allowing trading of these outstanding shares, the share price may fall. Information about the market overhang is available in the IPO prospectus.
Dual common stock is stock that has separate voting rights. Those with super-voting stock like the founders will continue to exert greater control over the company’s decisions even though they have lesser stocks. Investors must be cognizant of this fact and understand that they may not be able to influence company policy decisions despite having more stock than the super voters.
The stage of the company is an important consideration for investors. Is the company an emerging one or a mature one that is reorganizing?
Sarbanes-Oxley Stipulations Post IPO
An important element in determining a public company's profitability is the degree of investor confidence in the accuracy of financial reports. The internal control systems of a public company must adhere to all legal standards in order to assist maintain investor and market confidence.
These requirements typically take effect as of the second fiscal year-end following the IPO. It involves executive certifications on a quarterly basis as well as an audit report on the efficacy of Internal Control over Financial Reporting (ICFR) as provided under Section 404 of the Sarbanes-Oxley (SOX) Act.
- Evaluate the risks of general and specific fraud in the financial statements.
- Review the control environment, entity-level controls, and overall information technology (IT) controls
- Determine important accounts and disclosures
- Identify significant locations and business units
- Document processes containing significant classes of transactions
- Determine the main risk factors and mitigating measures.
- Provide preliminary assessment of the effectiveness of the design and the operation of key controls;
- Repair a lack of or inefficient controls;
- Conduct final tests to support a claim of effective internal controls over financial reporting, demonstrating consideration of the regulatory risks and environment.