The terms “Initial Public Offering” and “IPO” come up regularly in the world of finance and refer to a very important process in the life of a company. But what is an initial public offering? In this article, we will provide a thorough definition of an IPO, explain its advantages and disadvantages and much more!
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What Is an Initial Public Offering?
An Initial Public Offering, or IPO, is the name given to the process by which a private company issues new shares to sell to the public in order to raise capital and, in doing so, becomes a public company. This process of becoming a public, or listed, company is often referred to as “going public”.
Once a company has gone public, both its existing and newly issued shares can be bought and sold on the stock exchange to which it has listed (subject to any “lock-up” period, which we will expand on later).
In order to execute an IPO, a company must meet the requirements set forth by the relevant stock exchange and market regulator, such as the Financial Conduct Authority (FCA) in the UK or the Securities and Exchange Commission (SEC) in the US.
Why Go Public?
Before going public, a company will have grown with a relatively small number of shareholders, which are usually limited to founders, employees, family and professional investors through pre-IPO funding rounds.
During an IPO, as already explained, a company creates new shares which it sells to the public, raising a lot of capital in the process. But raising capital isn’t the only benefit to going public.
Becoming a listed company allows existing shareholders to sell their shares on the public market, something that is not possible for a private company, allowing them to liquidate some or all of their position. It also promotes public awareness of their business and improves their public profile and provides a certain level of prestige.
How Does an IPO Work?
In order to go public via an IPO, as well as preparing a registration statement to file with the relevant regulator, the company must also enlist the services of an investment bank who acts as the underwriter.
The investment bank underwrites the new shares, publicises the IPO by drumming up interest amongst institutional investors, values the company to decide an initial share price and helps sell the shares.
Furthermore, along with a team of lawyers, accountants and other experts, the investment bank will help the company navigate the regulatory requirements involved in going public.
Although the process is described as “going public”, the reality is that, usually, most retail investors are not able to access the new shares sold during an IPO. Instead, those new shares are sold mainly to institutional investors, other investment banks, hedge funds and more high-profile investors subject to their broker requirements. The majority of other retail traders will need to wait to purchase shares after the IPO, in the secondary market.
Benefits of Initial Public Offering
We explained earlier some of the benefits associated with a company going public, however, an IPO is not the only method a company can utilise to go public.
Companies can also choose to go public via a direct listing or by merging with, or being acquired by, a Special Purpose Acquisition Company (SPAC) – both of which are more recent phenomena. So, are there any benefits specifically associated with going public via the traditional route of an IPO?
The main advantage of an IPO over a direct listing or a SPAC is something we have already highlighted a couple of times; it allows companies to raise capital.
A successful IPO can generate an enormous amount of capital for a company thanks to the newly issued shares being made available to a far wider pool of investors than was previously possible. This capital may be earmarked for a particular purpose or just be used to fuel future growth.
Furthermore, part of the process of an IPO is that the investment bank helps build up interest and anticipation for the upcoming IPO at investor roadshows. This is particularly important for companies wanting to go public but who do not yet have a particularly strong or recognisable brand.
Disadvantages of IPO
The main disadvantage to going public via an IPO are the costs involved.
Whilst it is undeniable that the investment bankers who act as underwriters provide the company with a lot of valuable support during the IPO process, this is not done for free. Underwriters usually charge a fee which can range anywhere between 3% and 7% of the total money raised. This might not sound like a huge percentage but, for a large IPO, the underwriter can end up walking away with hundreds of millions of dollars.
Furthermore, part of an underwriters role during the IPO process is to value the company and set the initial share price by which the newly issued stock will be sold to investors. Underwriters are consistently accused of under-pricing shares during this process for two reasons:
- If the initial share price is low, the institutional investors who purchase shares at an IPO can benefit from the shares “popping” during the first trading session – something which happens regularly.
- Being the IPO’s underwriter requires the investment bank to step in and buy any shares which are left unsold during the process. The cheaper the shares are, the less chance there is of this happening and, if it does happen, the less exposure they have.
Lock-Up Period
The final disadvantage to an IPO only affects existing shareholders, but is an important aspect which deserves its own section.
Often, if you look at the price chart of a company after an IPO, you may notice that after a period of time, the share price takes a sudden downturn. This may be due to the end of the lock-up period.
Before the IPO goes live, existing shareholders are usually required to enter a lock-up agreement, which is a legally binding contract that precludes them from selling any of their shares for a pre-determined period of time, known as the lock-up period.
Typically, a lock-up period lasts between 90 – 180 days and is implemented by the underwriters to prevent the market becoming saturated, which may lead to the share price plummeting as soon as the listing is live.
Furthermore, it provides a certain level of reassurance to potential investors that existing shareholders are not merely taking the company public for a big pay day. It would hardly exude confidence if, on the first trading day, all the existing shareholders dumped their stock on the market.
Final Thoughts
You should now have good understanding of what an Initial Public Offering (IPO) is, how they work and some of their advantages and disadvantages.
Traditionally, IPOs were the main option for companies wanting to go public. However, in recent years, we have witnessed the rise in popularity of other listing methods, as companies attempt to gain the benefits of becoming a listed company without losing money to expensive underwriter fees.
However, for the time being, IPOs remain the most common route for companies wishing to list on the stock exchanges.
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