What you need to know about an Initial Public Offering (I.P.O)
What is an IPO?
An Initial Public Offering (IPO) refers to the process whereby a private corporation/company offers shares to the public in a new stock issuance. IPOs are issued by a private corporation with the view of raising capital from public investors to expand the business. Private corporations hire investment banks who subsequently take the role of researching, analyzing demand, setting the IPO price, amongst other things.
The Investment banks take up the role of an underwriter and will decide the number of shares to issue, the offering price, and the optimum time and type of security to be listed on a stock exchange.
The processes involved in an IPO
For an IPO to be undertaken, some processes must be followed. Some, depending on certain factors, are time consuming while some are not. However, here are the steps involved in a typical IPO process:
· Choose an IPO underwriter — The first step in an IPO process is for the issuing company to choose an Investment bank for advisory services on the IPO and also to provide underwriting services. The Investment banks help determine the initial offer price, buy the shares from the issuing company and then sell the shares to investors. Very often than not, they have a network of potential investors to reach out to in order to sell the shares. Most underwriters are selected based on the following criteria:
- Reputation
- Quality of Research
- Industry expertise
- Network distribution reach
- Prior relationship with the investment bank
- The underwriter past relationship with other companies
· Due Diligence — This is the most time-consuming part of the IPO process. In this step, there’s a pile of paperwork the company and underwriters fill out. The issuing company needs to register with the SEC (Securities and Exchange Commission) of the state it wants to issue shares. Then, there are contracts between the company and the underwriter. The agreements are as follows.
- Firm Commitment: This agreement states the underwriter will purchase all shares from the issuing company. They will resell them to the public.
- Best Efforts Agreements: Under such an agreement, the underwriter does not guarantee the amount that they will raise for the issuing company. It only sells the securities on behalf of the company.
- All or None agreements: Unless all of the offered shares can be sold, the offering is cancelled.
- Syndicate of Underwriters: Sometimes IPOs come with large risk, and the bank doesn’t want all of it. In this case, a group of banks will come together under the leading bank to form an alliance. This alliance allows each bank to sell part of the IPO, diversifying the risk.
· IPO Roadshow — An IPO roadshow is a traveling sales pitch. The underwriter and issuing company travel to various locations to present their IPO. They market the shares to investors to see what demand, if any, there is. Looking at investor interest, the underwriter can better estimate the number of shares to offer.
· IPO Pricing — Once approved by the SEC (Securities and Exchange Commission) the underwriter and company can decide the date, number of shares and the Initial Offer Price. It’s common for an IPO to be under-priced. When under-priced, investors will expect the price to rise, increasing demand. It also reduces the risk investors take by investing in an IPO, which could potentially fail.
· Going Public — Now that everything has been decided, its time for the issuing company to go public. On the agreed-upon date, the underwriter will release the initial shares to the market.
· Stabilization — There is a short window of opportunity where the underwriter can influence the share price. During the 25-day “quiet period,” which occurs immediately after the IPO, there are no rules preventing price manipulation. The underwriter ensures there’s a market and buyers to maintain an ideal share price.
Why does a company go public?
Prior to an IPO, a company is private with a relatively few number of shareholders, limited to accredited investors i.e.high net worth individuals and/or early investors i.e. the founder, family, and friends.
The main and primary reason for companies to go public is to raise capital. For example, a company may have a business plan or model of expanding but it may not have enough capital to fund the expansion. This would later make the company consider issuing shares with the view of generating money to fund the expansion. When the company goes public, it will be required by law to report its financial statements quarterly and annually for investors to know the current financial strength of the company. Increased transparency that comes with required quarterly reporting can usually help a company receive more favourable credit borrowing terms than as a private company.
A company’s image, prestige and exposure will be increased which can boost the company’s sales and profits. Public companies also have the options to issue secondary offerings — the sale of new or closely held shares by a company that has already made an initial public offering (IPO). This gives public company’s an additional option to generate funds.
When does a company go public?
A company typically goes public when it wants to raise money from new investors to fund future growth. Some companies may also tend to go public because a private shareholder may insist on selling their stake, or just to enhance their reputation in the public eye.
By Kehinde Agboola, for THE FINANCE HUB
