Initial public offering
Encyclopedia
An initial public offering (IPO) or stock market launch, is the first sale of stock by a private company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises. Many companies that undertake an IPO also request the assistance of an Investment Banking firm acting in the capacity of an underwriter to help them correctly assess the value of their shares, that is, the share price (IPO Initial Public Offerings, 2011).
was the first company in the world to issue stocks and bonds in an initial public offering (Chambers, 2006).
Facebook is currently preparing for an IPO.
, the money paid by investors for the newly issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of investors to provide itself with capital for future growth, repayment of debt or working capital. A company selling common shares is never required to repay the capital to investors.
Once a company is listed, it is able to issue additional common shares via a secondary offering, thereby again providing itself with capital for expansion without incurring any debt. This ability to quickly raise large amounts of capital from the market is a key reason many companies seek to go public.
There are several benefits to being a public company, namely:
The sale (allocation and pricing) of shares in an IPO may take several forms. Common methods include:
A large IPO is usually underwritten by a "syndicate
" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission
based on a percentage of the value of the shares sold (called the gross spread
). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions
—up to 8% in some cases.
Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements and because it is an expensive process, IPOs typically involve one or more law firm
s with major practices in securities law, such as the Magic Circle
firms of London and the white shoe firm
s of New York City.
Public offerings are sold to both institutional investors and retail clients of underwriters. A licensed securities salesperson ( Registered Representative
in the USA and Canada ) selling shares of a public offering to his clients is paid a commission from their dealer rather than their client. In cases where the salesperson is the client's advisor it is notable that the financial incentives of the advisor and client are not aligned.
In the US sales can only be made through a final prospectus cleared by the Securities and Exchange Commission.
Investment dealers will often initiate research coverage on companies so their Corporate Finance
departments and retail divisions can attract and market new issues.
The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe
or overallotment option.
as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters, however, have not taken to this strategy very well which is understandable given that auctions are threatening large fees otherwise payable. Though not the first company to use Dutch auction, Google
is one established company that went public through the use of auction. Google's share price rose 17% in its first day of trading despite the auction method. Brokers close to the IPO report that the underwriters actively discouraged institutional investors from buying to reduce demand and send the initial price down. The resulting low share price was then used to "illustrate" that auctions generally don't work.
Perception of IPOs can be controversial. For those who view a successful IPO to be one that raises as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open market—more institutions bid, fewer private individuals bid. Google may be a special case, however, as many individual investors bought the stock based on long-term valuation shortly after it launched its IPO, driving it beyond institutional valuation.
Historically, some of IPOs both globally and in the United States have been underpriced. The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it first becomes publicly traded. Through flipping
, this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in "money left on the table"—lost capital that could have been raised for the company had the stock been offered at a higher price. One great example of all these factors at play was seen with theglobe.com
IPO which helped fuel the IPO mania of the late 90's internet era. Underwritten by Bear Stearns
on November 13, 1998, the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock. Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.
Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the underwriters ("syndicate") arranging share purchase commitments from leading institutional investors.
On the other hand, some researchers (e.g. Geoffrey C., and C. Swift, 2009) believe that IPOs are not being under-priced deliberately by issuers and/or underwriters, but the price-rocketing phenomena on issuance days are due to investors' over-reaction (Friesen & Swift, 2009).
Some algorithms to determine underpricing: IPO Underpricing Algorithms
.
Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificate
s to the clearing agent bank's custodian, or a delivery versus payment
(DVP) arrangement with the selling group brokerage firm.
The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. Regulatory changes enacted by the SEC
as part of the Global Settlement
enlarged the "quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over, generally the underwriters will initiate research coverage on the firm. Additionally, the NASD and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-up agreement" for a securities offering.
A stag is a party or individual who subscribes to the new issue expecting the price of the stock to rise immediately upon the start of trading. Thus, stag profit
is the financial gain accumulated by the party or individual resulting from the value of the shares rising.
For example, one might expect a certain I.T.
company to do particularly well and purchase a large volume of their stock or shares before flotation on the stock market. Once the price of the shares has risen to a satisfactory level the person will choose to sell their shares and make a stag profit.
History
In 1602, the Dutch East India CompanyDutch East India Company
The Dutch East India Company was a chartered company established in 1602, when the States-General of the Netherlands granted it a 21-year monopoly to carry out colonial activities in Asia...
was the first company in the world to issue stocks and bonds in an initial public offering (Chambers, 2006).
Facebook is currently preparing for an IPO.
Reasons for listing
When a company lists its securities on a public exchangeStock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...
, the money paid by investors for the newly issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of investors to provide itself with capital for future growth, repayment of debt or working capital. A company selling common shares is never required to repay the capital to investors.
Once a company is listed, it is able to issue additional common shares via a secondary offering, thereby again providing itself with capital for expansion without incurring any debt. This ability to quickly raise large amounts of capital from the market is a key reason many companies seek to go public.
There are several benefits to being a public company, namely:
- Bolstering and diversifying equity base
- Enabling cheaper access to capital
- Exposure, prestige and public image
- Attracting and retaining better management and employees through liquid equity participation
- Facilitating acquisitions
- Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.
- Increased liquidity for equity holder
Disadvantages of an IPO
There are several disadvantages to completing an initial public offering, namely:- Significant legal, accounting and marketing costs
- Ongoing requirement to disclose financial and business information
- Meaningful time, effort and attention required of senior management
- Risk that required funding will not be raised
- Public dissemination of information which may be useful to competitors, suppliers and customers
Procedure
IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.The sale (allocation and pricing) of shares in an IPO may take several forms. Common methods include:
- Best efforts contract
- Firm commitment contract
- All-or-none contract
- Bought dealBought dealA bought deal occurs when an underwriter, such as an investment bank or a syndicate, purchases securities from an issuer before a preliminary prospectus is filed. The investment bank acts as principal rather than agent and thus actually "goes long" in the security...
- Dutch auctionDutch auctionA Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price is reached. The winning participant pays the last announced price...
A large IPO is usually underwritten by a "syndicate
Syndicate
A syndicate is a self-organizing group of individuals, companies or entities formed to transact some specific business, or to promote a common interest or in the case of criminals, to engage in organized crime...
" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
based on a percentage of the value of the shares sold (called the gross spread
Gross spread
Gross spread refers to the fees that underwriters receive for arranging and underwriting an offering of debt or equity securities. The gross spread for an initial public offering can be higher than 10% while the gross spread on a debt offering can be as low as 0.05%.For example, if a company sells...
). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
—up to 8% in some cases.
Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements and because it is an expensive process, IPOs typically involve one or more law firm
Law firm
A law firm is a business entity formed by one or more lawyers to engage in the practice of law. The primary service rendered by a law firm is to advise clients about their legal rights and responsibilities, and to represent clients in civil or criminal cases, business transactions, and other...
s with major practices in securities law, such as the Magic Circle
Magic Circle (law)
The "Magic Circle" is an informal term used to collectively describe what are generally regarded to be the five leading UK-headquartered law firms and the four or five leading London-based commercial barristers' chambers.-Law firms:...
firms of London and the white shoe firm
White shoe firm
White shoe firm is a phrase used to describe the leading professional services firms in the United States, particularly firms that have been in existence for more than a century and represent Fortune 500 companies...
s of New York City.
Public offerings are sold to both institutional investors and retail clients of underwriters. A licensed securities salesperson ( Registered Representative
Registered Representative
A Registered Representative, also called a General Securities Representative, a Stock Broker, or an Account Executive, is an individual who is licensed to sell securities and has the legal power of an agent....
in the USA and Canada ) selling shares of a public offering to his clients is paid a commission from their dealer rather than their client. In cases where the salesperson is the client's advisor it is notable that the financial incentives of the advisor and client are not aligned.
In the US sales can only be made through a final prospectus cleared by the Securities and Exchange Commission.
Investment dealers will often initiate research coverage on companies so their Corporate Finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
departments and retail divisions can attract and market new issues.
The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe
Greenshoe
A greenshoe , legally called an "over-allotment option" , gives underwriters the right to sell additional shares in a registered securities offering at the offering price, if demand for the securities exceeds the original amount offered...
or overallotment option.
Auction
A venture capitalist named Bill Hambrecht has attempted to devise a method that can reduce the inefficient process. He devised a way to issue shares through a Dutch auctionDutch auction
A Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price is reached. The winning participant pays the last announced price...
as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters, however, have not taken to this strategy very well which is understandable given that auctions are threatening large fees otherwise payable. Though not the first company to use Dutch auction, Google
Google
Google Inc. is an American multinational public corporation invested in Internet search, cloud computing, and advertising technologies. Google hosts and develops a number of Internet-based services and products, and generates profit primarily from advertising through its AdWords program...
is one established company that went public through the use of auction. Google's share price rose 17% in its first day of trading despite the auction method. Brokers close to the IPO report that the underwriters actively discouraged institutional investors from buying to reduce demand and send the initial price down. The resulting low share price was then used to "illustrate" that auctions generally don't work.
Perception of IPOs can be controversial. For those who view a successful IPO to be one that raises as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open market—more institutions bid, fewer private individuals bid. Google may be a special case, however, as many individual investors bought the stock based on long-term valuation shortly after it launched its IPO, driving it beyond institutional valuation.
Pricing
The underpricing of initial public offerings (IPO) has been well documented in different markets (Ibbotson, 1975; Ritter 1984; Levis, 1990; McGuinness, 1992; Drucker and Puri, 2007). While issuers always try to maximize their issue proceeds, the underpricing of IPOs has constituted a serious anomaly in the literature of financial economics. Many financial economists have developed different models to explain the underpricing of IPOs. Some of the models explained it as a consequences of deliberate underpricing by issuers or their agents. In general, smaller issues are observed to be underpriced more than large issues (Ritter, 1984, Ritter, 1991, Levis, 1990)Historically, some of IPOs both globally and in the United States have been underpriced. The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it first becomes publicly traded. Through flipping
Flipping
Flipping is a term used primarily in the United States to describe purchasing a revenue-generating asset and quickly reselling it for profit...
, this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in "money left on the table"—lost capital that could have been raised for the company had the stock been offered at a higher price. One great example of all these factors at play was seen with theglobe.com
TheGlobe.com
theGlobe.com was an internet startup founded in 1994 by Cornell students Stephan Paternot and Todd Krizelman. A social networking service, theGlobe.com made headlines by going public on November 13, 1998 and posting the largest first day gain of any IPO in history up to that date...
IPO which helped fuel the IPO mania of the late 90's internet era. Underwritten by Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
on November 13, 1998, the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock. Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.
Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the underwriters ("syndicate") arranging share purchase commitments from leading institutional investors.
On the other hand, some researchers (e.g. Geoffrey C., and C. Swift, 2009) believe that IPOs are not being under-priced deliberately by issuers and/or underwriters, but the price-rocketing phenomena on issuance days are due to investors' over-reaction (Friesen & Swift, 2009).
Some algorithms to determine underpricing: IPO Underpricing Algorithms
IPO Underpricing Algorithms
IPO underpricing, is the increase in stock value from the initial offering price to the first-day closing price. Many believe that underpriced IPOs leave money on the table for corporations, but some believe that underpricing is inevitable. Investors state that underpricing signals high interest to...
Issue price
A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price (fixed price method) or the price is arrived at through the process of book buildingBook building
Book building refers to the process of generating, capturing, and recording investor demand for shares during an IPO in order to support efficient price discovery. Usually, the issuer appoints a major investment bank to act as a major securities underwriter or bookrunner...
.
Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificate
Stock certificate
In corporate law, a stock certificate is a legal document that certifies ownership of a specific number of stock shares in a corporation...
s to the clearing agent bank's custodian, or a delivery versus payment
Delivery versus payment
"Payment at the moment of delivery".Delivery versus payment or DVP is a sale transaction of negotiable securities that can be instructed to a settlement agent using SWIFT Message Type MT 543...
(DVP) arrangement with the selling group brokerage firm.
Quiet period
There are two time windows commonly referred to as "quiet periods" during an IPO's history. The first and the one linked above is the period of time following the filing of the company's S-1 but before SEC staff declare the registration statement effective. During this time, issuers, company insiders, analysts, and other parties are legally restricted in their ability to discuss or promote the upcoming IPO (U.S. Securities and Exchange Commission, 2005).The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. Regulatory changes enacted by the SEC
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
as part of the Global Settlement
Global settlement
The Global Settlement was an enforcement agreement reached on April 28, 2003 between the SEC, NASD, NYSE, and ten of the United States's largest investment firms to address issues of conflict of interest within their businesses-Settlement Decision:...
enlarged the "quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over, generally the underwriters will initiate research coverage on the firm. Additionally, the NASD and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-up agreement" for a securities offering.
Stag profit
Stag profit is a stock market term used to describe a situation before and immediately after a company's Initial public offering (or any new issue of shares).A stag is a party or individual who subscribes to the new issue expecting the price of the stock to rise immediately upon the start of trading. Thus, stag profit
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
is the financial gain accumulated by the party or individual resulting from the value of the shares rising.
For example, one might expect a certain I.T.
Information technology
Information technology is the acquisition, processing, storage and dissemination of vocal, pictorial, textual and numerical information by a microelectronics-based combination of computing and telecommunications...
company to do particularly well and purchase a large volume of their stock or shares before flotation on the stock market. Once the price of the shares has risen to a satisfactory level the person will choose to sell their shares and make a stag profit.
Largest IPOs
- Agricultural Bank of ChinaAgricultural Bank of ChinaAgricultural Bank of China Limited , also known as AgBank, is one of the "Big Four" banks in the People's Republic of China. It was founded in 1951, and has its headquarters in Beijing...
$22.1 billion (2010) - Industrial and Commercial Bank of ChinaIndustrial and Commercial Bank of ChinaIndustrial and Commercial Bank of China Ltd. is the largest bank in the world by profit and market capitalization. It is one China's 'Big Four' state-owned commercial banks .It was founded as a limited company on January 1, 1984...
$21.9 billion (2006) - American International AssuranceAmerican International AssuranceAmerican International Assurance known as AIA is an insurance company based in Hong Kong. It has offices in Asia-Pacific region including Taiwan, China, Australia, New Zealand, Japan, India, Malaysia, Macau, South Korea, Thailand, Philippines, Singapore, Brunei and Vietnam...
$20.5 billion (2010) - Visa Inc. $19.7 billion (2008)
- General MotorsGeneral MotorsGeneral Motors Company , commonly known as GM, formerly incorporated as General Motors Corporation, is an American multinational automotive corporation headquartered in Detroit, Michigan and the world's second-largest automaker in 2010...
$18.1 billion (2010)
See also
- Alternative public offeringAlternative Public OfferingAn alternative public offering is the combination of a reverse merger with a simultaneous private investment of public equity . It allows companies an alternative to an initial public offering as a means of going public while raising capital.-Overview:There are two parts that comprise an APO:...
- Direct public offeringDirect public offeringA Direct Public Offering is similar to an Initial Public Offering in that stock is sold to investors, but unlike an IPO, a company uses a DPO to raise capital directly and without the assistance of an investment banking firm or broker-dealer...
- Equity carve-outEquity carve-outEquity carve-out is a sort of corporate reorganization, in which a company creates a new subsidiary and IPOs it later, while retaining control. Usually, up to 20% of subsidiary shares is offered to the public. The transaction creates two separate legal entities—parent company and daughter...
- Mergers and acquisitionsMergers and acquisitionsMergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
(M&A) - Private placementPrivate placementPrivate placement is a funding round of securities which are sold without an initial public offering, usually to a small number of chosen private investors...
- Public offering without listingPublic offering without listingA public offering without listing, often called a POWL deal or a POWL, is a form of public equity offering by non-Japanese firms in the Japanese market, without the previously required simultaneous listing on a local exchange A public offering without listing, often called a POWL deal or a POWL, is...
- Reverse IPO
- Seasoned equity offeringSeasoned equity offeringA Seasoned equity offering or secondary equity offering is a new equity issue by an already publicly-traded company. Secondary offerings may involve shares sold by existing shareholders , new shares or both....
- SEC Form S-1 (Registration form for certain types of issuers)
- Secondary market offeringSecondary Market OfferingA secondary market offering, according to the U.S. Financial Industry Regulatory Authority , is a registered offering of a large block of a security that has been previously issued to the public. The blocks being offered may have been held by large investors or institutions, and proceeds of the...
- Venture capitalVenture capitalVenture capital is financial capital provided to early-stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as...
External links
- Initial Public Offering (IPO) Definition and Calendar, Wikinvest
- How IPO works- HowStuff Works
- Most Recent IPO SEC Filings (Form S-1)