Initial Public Offering (IPO)
What Is an Initial Public Offering (IPO) ?
The process of issuing shares of a private firm to the public in a fresh stock issuance is known as an initial public offering (IPO). An initial public offering (IPO) allows a firm to raise funds from the general public. The move from a private to a public firm, which often involves a share premium for current private investors, can be a crucial opportunity for private investors to completely realize rewards from their investment. Meanwhile, public investors are allowed to participate in the offering.
How Does It Work?
A corporation is deemed private before it goes public. The firm has expanded with a limited number of stockholders as a pre-IPO private company, comprising early investors such as the founders, family, and friends, as well as professional investors such as venture capitalists and angel investors.
An initial public offering (IPO) is a significant milestone for a company since it allows it to raise significant funds. This increases the company’s capacity to expand and grow. The enhanced transparency and legitimacy of its stock listing may also help the company acquire better terms when seeking borrowed capital.
When a firm believes it is mature enough for the rigors of SEC laws, as well as the rewards and responsibilities that come with being a public company, it will begin to promote its interest in going public.
This stage of development usually occurs when a company has reached a private valuation of $1 billion or more, commonly known as unicorn status. However, depending on market competition and their capacity to meet listing standards, private companies with good fundamentals and proven profitability potential can potentially qualify for an IPO.
Underwriting due diligence is used to price a company’s IPO shares. When a corporation goes public, private share ownership transforms to public ownership, and existing private shareholders’ shares are valued at the public market price. Special provisions for private to public share ownership can be included in share underwriting.
Meanwhile, the public market provides millions of investors with the option to purchase shares in a company and contribute funds to its shareholders’ equity. Any individual or institutional investor that is interested in investing in the company is considered a member of the public.
Overall, the number of shares sold and the price at which they are sold are the main variables for the equity value of the company’s new shareholders. When it is both private and public, shareholders’ equity still represents shares owned by investors, but with an IPO, shareholders’ equity expands dramatically with cash from the initial issuance.
A Brief History of Initial Public Offerings
For decades, the term “initial public offering” has been a buzzword on Wall Street and among investors. By selling shares in the Dutch East India Company to the general public, the Dutch are credited with launching the first modern IPO.
Since then, IPOs have been utilized as a means for corporations to generate funds from the general public by issuing public shares.
IPOs have been recognized for uptrends and downtrends in issuance over the years. Individual industries also go through ups and downs in issuance as a result of innovation and other economic considerations. At the height of the dot-com bubble, tech IPOs exploded as firms with no revenue hurried to list on the stock exchange.
The financial crisis of 2008 resulted in the lowest number of initial public offerings (IPOs) ever. Following the financial crisis of 2008, IPOs came to a halt, and fresh listings became scarce for several years.
Much of the recent IPO hype has been on so-called unicorns—startups with private valuations of more than $1 billion. Investors and the media speculate a lot about these companies and whether they will go public via an IPO or remain private.
The Initial Public Offering (IPO) Process
An initial public offering (IPO) is divided into two sections. The first is the offering’s pre-marketing phase, and the second is the actual first public offering. When a company wants to do an IPO, it will either request private bids from underwriters or make a public declaration to attract interest.
The underwriters are picked by the company to lead the IPO process. A company may select one or more underwriters to collaborate on various aspects of the IPO process. Every step of the IPO due diligence, document preparation, filing, marketing, and issuance is handled by the underwriters.
Steps to an Initial Public Offering
Underwriters give proposals and valuations outlining their services, the best form of security to issue, the offering price, the number of shares to be issued, and the market offering’s projected period.
The corporation selects its underwriters and enters into an underwriting agreement with them to formally agree on underwriting terms.
Lawyers, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) professionals create IPO teams.
4. Accurate documentation
For the needed IPO papers, information on the company is prepared. The principal IPO filing document is the S-1 Registration Statement. There are two elements to it: the prospectus and the confidential filing information.
The S-1 contains preliminary information regarding the projected filing date. Throughout the pre-IPO process, it will be updated often. The prospectus that comes with the package is also updated regularly.
5. Promotions & Updates
For the pre-marketing of the new stock issuance, marketing materials are prepared. To evaluate demand and set a final offering price, underwriters and executives publicize the share issuance. Throughout the marketing process, underwriters can make changes to their financial analyses. This could involve adjusting the IPO price or issuance date as needed.
Companies take the required actions to meet the standards for public stock offerings. For public corporations, both exchange listing criteria and SEC regulations must be met.
6. Board of Directors and Procedures
Form a board of directors and make sure there are procedures in place for reporting auditable financial and accounting data every quarter.
The company’s shares are issued on an initial public offering (IPO) date. The capital received as cash from the primary issuance is reported as stockholders’ equity on the balance sheet. As a result, the balance sheet share value is entirely determined by the company’s stockholders’ equity per share valuation.
8. After the IPO
Some post-IPO provisions may be implemented. After the initial public offering (IPO) date, underwriters may have a limited time to purchase additional shares. During this time, certain investors may experience a period of silence.
Benefits of an Initial Public Offering
1. Raising funds
Money is the most frequently mentioned benefit of an initial public offering. The median proceeds from an initial public offering (IPO) in 2016 were $94.5 million, with numerous IPOs raising hundreds of millions of dollars. The greatest IPO in 2016, for example, was ZTO Express, which raised $1.4 billion. Even without considering the other benefits, the proceeds from an IPO provide adequate motivation for many companies to go public, especially given the numerous investment options available as a result of the extra capital.
This money can help a growing business in a variety of ways. An initial public offering can be used to fund research and development, hire new personnel, build facilities, decrease debt, fund capital expenditure, acquire new technologies or other companies, or a variety of other things. An IPO provides a large sum of money that can drastically alter a company’s growth trajectory.
2. Exit Possibility
Stakeholders in any firm have invested substantial time, money, and resources in the hopes of building a successful business. For years, these founders and investors may not see a meaningful financial return on their investments. An initial public offering (IPO) provides investors with a huge exit option, allowing them to possibly obtain large sums of money or, at least, liquefy the cash they have invested in the company.
Initial public offerings, as noted in the preceding paragraph, frequently raise approximately $100 million (or even more), making them very appealing to founders and investors who believe it is time to earn a financial reward for years of “sweat equity.” It’s worth noting, though, that for founders and investors to get cash from an IPO, they’ll have to sell their shares in the now-public firm on a secondary market (e.g., New York Stock Exchange). The proceeds of an IPO do not provide liquidity to shareholders right away.
3. Publicity And Trustworthiness
An IPO can provide this exposure by thrusting a firm into the public spotlight. If a company intends to continue to grow, it will require increased exposure to potential customers who are familiar with and trust its products. Every initial public offering is covered by analysts all around the world to help their clients decide whether or not to invest, and numerous news organizations cover different firms that are going public.
When a company decides to go public, it receives not just a lot of attention, but also a lot of credibilities. To complete an offering, a company must undergo a rigorous inspection to ensure that the information they are disclosing about themselves is accurate. This examination, combined with the fact that many people trust public corporations more, can boost a company’s and its goods’ credibility.
4. Lower Total Cost Of Capital
The cost of financing is a key barrier for any company, but notably for smaller private companies. Companies must typically pay higher interest rates or give up ownership to collect funding from investors before an IPO. An IPO can greatly reduce the difficulties of obtaining new financing.
Before a firm can begin the formal IPO preparation process, it must be audited according to PCAOB standards; this audit is typically more thorough than previous audits, and it provides more assurance that the information being reported is true.
Because the organization is viewed as less hazardous, this enhanced confidence will likely result in lower interest rates on bank loans. Aside from cheaper borrowing rates, after a firm becomes public, it can raise more money through successive stock market offerings, which is usually easier than raising money through a private investment round.
5. Stock as a Payment Method
Being a publicly-traded company also allows you to pay with publicly traded stock. While a private company’s stock can be used as payment, the private stock is only useful if a suitable exit4 opportunity presents itself. Public stock, on the other hand, is a sort of cash that can be purchased and sold at any time at a market price, which can be useful when rewarding staff and acquiring other firms. For a business to succeed, it must hire the appropriate people.
When it comes to hiring top-tier talent, the flexibility to pay employees in stock or provide stock options helps a company to compete even if the base monetary compensation is lower than what competitors are giving. Furthermore, acquisitions are frequently a crucial strategy for businesses to continue to expand and remain relevant. Purchasing other businesses, on the other hand, is usually highly costly. When a company goes public, it can issue shares of its stock instead of spending millions of dollars in cash as a form of payment.
1. Additional Disclosures And Regulatory Requirements
Public firms, unlike private companies, are required to file annual financial statements with the Securities and Exchange Commission (SEC). These financial statements must be prepared by Generally Accepted Accounting Principles (GAAP) in the United States and must be audited by a registered public accounting firm. These SEC standards are both time-consuming and expensive.
Establishing more stricter financial controls, staffing a financial reporting team and audit committee, implementing quarterly and yearly financial closure processes, hiring an audit firm, and hundreds of additional duties are all required when a company’s financial situation is publicly reported. Every year, these responsibilities cost public firms millions of dollars and thousands of hours of effort. See our article Audit Preparation for the Big Leagues for more information on public company audits.
2. Market Constraints
For company leaders who are accustomed to doing what they believe is best for the organization, market pressures can be extremely challenging. Founders often have a long-term view of their firm, seeing what it will look like years from now and how it will affect the world. The stock market, on the other hand, has a profit-driven, short-term perspective.
When a company goes public, every move it makes is analyzed by investors and analysts all over the world, who are mostly concerned with one question: “Will this company fulfill its quarterly earnings target?” If a corporation achieves its goal, its stock price will often rise; if it does not, it will typically fall. Even if leadership is acting in the long-term best interests of the company, failing to achieve the public’s short-term goals may cause the company to lose value, and leadership may be removed as a result. Founders who dislike the idea of being restricted by short-term public aims may consider going public with caution.
3. The Possibility Of Losing Control
One of the most significant disadvantages of an IPO is that founders may lose ownership of their business. While there are ways to ensure that the business’s founders retain the bulk of decision-making power, once a company becomes public, the leadership must satisfy the public, even if other shareholders do not have voting power. Going public entails getting significant funds from public shareholders.
Because shareholders have invested so much in the company, they expect it to operate in their best interests, even if that means going in a path that the founders don’t like. If shareholders believe the firm is not running in a way that will help them gain money, they can push the corporation to choose new leadership through shareholder votes or public criticism.
4. Costs of Transactions
Initial public offerings (IPOs) are costly. Aside from the ongoing costs of public firm regulatory compliance, the IPO transaction process is expensive. Underwriter5 fees are the most expensive part of a public offering. Underwriters normally charge between 5% and 7% of the gross proceeds, which implies the underwriter’s discount on a typical IPO can cost up to $7 million.
In addition to underwriter fees, corporations raising an average amount of cash (about $100 million) should budget for legal fees of $1.5–2 million, auditor fees of $1 million, and registration and printing fees of $500,000.
Things to consider before investing in an initial public offering
Indian companies have collected more than Rs 27,417 crore through initial public offers (IPOs) in the first six months of this year, the most in at least a decade, thanks to an abundance of liquidity and investor enthusiasm. The majority of money raised through IPOs, on the other hand, were used to provide an exit to existing PE or VC firms, as well as existing shareholders and promoters.
Calendar 2021 is expected to be a record year for IPO investing in India, with a huge number of IPOs scheduled for the following months. The 2020 IPO stocks are currently trading at a premium to their issue prices, with some gaining as much as 400% since their initial public offering. All of this makes IPO investment an appealing alternative for newcomers to the market. Paytm, Bajaj Energy, Nykaa, and LIC are among the big names set to launch before the end of the financial year.
However, just like the stock market, initial public offerings (IPOs) include a certain amount of risk, and due investigation is essential before investing in them. Here are some things to consider if you decide to invest in an initial public offering:
1. Always read the Red Herring Prospectus: When a company wants to collect money from the public by selling shares of the firm to investors, it must file a Draft Red Herring Prospectus with Sebi. The DRHP also explains how the company plans to use the funds received and the dangers that investors may face. As a result, before investing in an IPO, investors must read the DRHP.
2. Profits Utilization: It is critical to understand how the proceeds from the IPO will be used. If the company says it will only pay off debt, it may not be an appealing option to consider; however, if the company plans to raise funds to partially pay off debt and expand the business, or to use the money for general corporate purposes, it shows that the money will flow into the company, which is good for investors.
3. Grasp the Business: Before investing, it is important to understand the nature of the company’s business. The next step is for her to recognize the new market potential once she has grasped the business. Because, when it comes to growth and shareholder returns, the size of the opportunity and the company’s ability to acquire market share can make all the difference. On the other hand, if an investor’s business activities are unknown, he or she should avoid an IPO.
4. Background of the promoters and management team: An investor should look at who is running the business. It’s crucial to look at the company’s promoters and managers, who are responsible for all of the company’s operations and functions. It is the responsibility of the company’s management to move it forward. The average number of years spent in the company by top management also gives you an indication of the organization’s working culture.
5. Market potential of the company: As public awareness of the company grows around the time of an IPO, investors can assess the company’s market potential to better comprehend its future possibilities. If the company does well after raising funds, investors will see a large return on their IPO investment. The company that makes an initial public offering (IPO) should have a solid business plan that can be sustained in the long run.
6. The company’s primary strengths and strategy: The DRHP can help investors figure out the company’s key strengths. It’s also a good idea to look at the company’s position in the industry it operates in. One can get a sense of the company’s future prospects by learning more about it, its positioning, and strategies.
7. Company financial health and valuations: The company’s financial performance should be evaluated in terms of whether revenues and profits have increased or decreased over the last several years. It would be an excellent investment if revenues and earnings were to rise. Before purchasing an IPO, investors should endeavor to evaluate the company’s financial health. Check the values as well, because based on the industry specifications and profitability measures, the offer price may be low, reasonably valued, or overvalued.
8. Company valuation comparison: Investors should research the company’s competitors. The DHRP will make comparisons to its peers, both in terms of financial data and values. Comparative values can be used to see if the company’s valuations are in line with its peers.
9. Major risk variables: The DRHP can help investors determine out the risk elements. It’s critical to read the risk factors to see if there are any serious worries or risks related to the organization. Certain litigations and liabilities, particularly contingent liabilities, can sometimes put the company’s future business prospects in jeopardy.
10. The Investment Horizon of the Investor: An investor should have a defined investment horizon. One must decide if she wants to invest in the IPO to earn a rapid profit on the day of the listing or whether she wants to hold the shares for a longer period. Because a short-term strategy is based on current market sentiment, but a long-term strategy is based on the company’s fundamentals.
Furthermore, an investor should conduct her study. Only if she believes in the company’s long-term growth potential can she contemplate investing in the IPO. The grey market premium should not be used to evaluate an IPO. Initial public offerings (IPOs) can provide excellent opportunities to purchase a stock at a bargain price. So, if one comes across a company that is undervalued, one should take advantage of the situation. However, one should only invest in an IPO if it aligns with her financial objectives and risk tolerance.
When it comes to the stock market, time is everything — when you enter and when you quit. During the IPO, the timing is sometimes ideal, and other times it is preferable to wait. Make a judgment based on how much risk you’re willing to accept and how strong the company’s fundamentals are in terms of valuation. Keep your skepticism at bay. When it comes to the IPO market, a well-informed skeptic has a better chance of succeeding.