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While an initial public offering (IPO) sounds like an event, an IPO is a process.
This complex process provides an opportunity for general investors to make a public company a part of their portfolio.
The goals for the IPO process include:
- Converting a private company to a public company.
- Creating an opportunity for companies to raise capital through the primary market.
- Providing an opportunity for early investors such as venture capitalists or angel investors to cash out.
Breaking into the public market may sound straightforward, but the IPO process involves several steps and can take a considerable length of time.
What Is an IPO?
An IPO is when a company "goes public." As part of the IPO process, the company structures its shares for sale and must meet regulatory compliance standards set by the U.S. Securities and Exchange Commission (SEC) related to financial disclosures and transparency, which protects investors from fraud.
Because the IPO process takes considerable time, effort, and money, a company may choose to go through an IPO readiness assessment before starting this process.
Successful companies with proven profitability and the ability to meet the many requirements may qualify for and opt for an IPO, with some of these companies having reached a private valuation of $1 billion.
When a company decides to go public, it has decided that it is ready and willing to meet both SEC regulations and responsibilities to public shareholders.
Why Are IPOs Important for Companies?
A company may start to explore the IPO process when looking for additional funding sources.
These discussions may arise when a private company has difficulty raising capital. Or maybe it has grown too large to be bought out by another company. Another possibility is that the venture capitalists or private equity firms who funded the company want to realize their profit and cash out.
By putting the company onto the public market, a successful company can continue raising capital to fund growth.
Pros and Cons to the IPO Process
The IPO process can raise a significant amount of money for a company in a short amount of time. For example, Lyft raised $2.2 billion at its initial public offering in 2019.
IPOs can benefit a company's public image because of the financial accountability that the public feels the company is subject to. The combination of a positive public image and more exposure may also contribute to increased profits.
Going public and having increased transparency may help a company receive more favorable credit borrowing terms than it would as a private company.
The IPO process can help a company attract and retain better employees, including those employees at the management level. These employees may be attracted to a company where they can be compensated through liquid stock equity participation or through stock compensation at the IPO.
Additionally, IPOs may help employees of a company. If a private company paid employees with equity, these employees may be eager to unload some of this equity. After all, it's tough to pay bills with equity.
It's also important to note that a company that's gone public can return to private. There could be a buyout from a group of investors in which they purchase a majority of the shares in that company. When this occurs, the company is delisted from public exchange.
The IPO process timeline can take four to six months and create a challenge for the directors of a company, as they are required to disclose a tremendous amount of information. This information includes: financial, accounting, tax, and other business information.
The IPO process includes other challenges as well, such as:
- Causing the original leaders or executives to lose control over the company.
- Placing a company under extreme scrutiny from analysts, government regulators, and the media.
- Expenses that include legal, accounting, and marketing costs.
Understanding the IPO Process Can Help Both Investors and Business Owners
The IPO process has several steps. These steps include a pre-marketing phase and the initial public offering itself.
The IPO procedure for the pre-marketing steps includes:
- Choosing a bank.
- Completing the IPO due diligence process.
- Filing an IPO prospectus with the SEC.
- Going on a "road show" to encourage investors.
- Determining the IPO price.
The initial public offering process itself includes:
- Going public.
- Transitioning to market competition.
Choosing an Investment Bank and Premarketing
The banks from which companies choose to go through the IPO process must be registered with the SEC. These banks act as underwriters and are specialists in this area.
An underwriter assumes financial risk for a fee, and the specialists include certified public accountants (CPAs) and SEC experts.
Investment banks help determine the initial offer price, purchase the shares from the issuing company, and sell those shares to investors.
Companies will frequently advertise to underwriters by making public statements or asking for private bids. A company may choose one or multiple underwriters with different underwriters handling different aspects of the process.
The premarketing also starts at this point in the process with the creation of the IPO prospectus. The IPO prospectus is initially filed with the SEC as a confidential document before being publicly released. It contains everything investors need to know about the company, such as risk factors and audited financial statements.
The IPO Due Diligence Process
The IPO due diligence process requires a considerable amount of paperwork for both the company and for the underwriters. This process is the most time consuming. The paperwork for this process includes the IPO filing process required for the SEC as well as the contracts between the company and the underwriting investment bank.
There are multiple contracts between the company and the underwriter. These contracts include the commitments between the company and the underwriter related to purchasing shares, assuming and sharing risk, and covering expenses.
Additionally, the company will agree to provide the underwriter with information about the company's operations and prospects. The underwriter will agree to purchase a certain number of shares at a particular price.
During this part of the IPO process timeline, the company will form a board of directors and develop a process for reporting financial and accounting information each quarter.
Going on a "Road Show"
At this point in the IPO process, the IPO prospectus becomes an important source of information for potential investors. The prospectus includes information about the company's business operations and management, in addition to the audited financial statements.
Throughout the road show, investors may communicate directly with company executives, as the issuing company and the underwriter pitch their IPO shares. The issuing company may also produce advertising and secure media coverage for this part of the process as well – building excitement can create investor interest and yield significant profits.
On the last day of the road show, before trading begins, the issuing company and the underwriter work to determine the price for the soon-to-be-issued stocks. The aim is to have at least three times the interest in its shares than the company will make available, and the hype around the road show can contribute to the demand.
Determining the IPO Price
With the information from the road show, the underwriter and the company can make multiple determinations. These include:
- The effective date of the IPO.
- The number of shares offered.
- The initial offer price.
It's important for investors to understand the valuation of a company before the excitement of the road show and before the stocks are issued. Knowing the value of a company prior to its going public can help an investor determine if a stock is overpriced or underpriced at the IPO.
A low price could signal little interest, and a high price could warn of a potential drop once trading begins.
The company then "goes public" to sell shares on the agreed-upon date. This process is done in the following order:
No. 1: Stabilization
During a 25-day window, the underwriter can influence the share price, and there are no rules preventing price manipulation. This period ensures that there's both a market and buyers for the shares.
When a company releases stock, it starts a lock-up period of up to 180 days. During this period of time, initial investors who want to liquidate their equity in the company have to wait before selling their stock. This waiting period avoids the market being flooded with shares and driving the price down.
Some investors may be involved in flipping the stock. This practice includes buying then reselling an IPO stock within the first few days of issuance to earn a quick profit.
No. 2: Transitioning to Market Competition
After the 25-day window, the underwriters and the investors transition out of being in the underwriter's control. The underwriter becomes an advisor, and the company becomes public and part of the market.
Alternative Paths to the IPO
Although IPOs make great headlines, the process has grown increasingly less common. Companies find other ways to raise capital. Some companies go public without an IPO in a process called a "direct listing." Direct listings enable companies to sell shares directly to the public without the underwriting of a Wall Street bank.
Direct listings also enable companies to avoid the scrutiny that comes with an IPO.
It's also possible to go public without setting an IPO price through a Dutch auction. A Dutch auction involves buyers being able to bid for the shares that they want at the price that they are willing to pay.
Some companies may break off a part of the business to stand alone with the newly formed entity going through the IPO process. This may happen at a company where different divisions have different values, and raising capital for one division proves difficult.
The IPO process is complex, challenging, and involves multiple entities. Yet going through the IPO process offers a company the opportunity to raise significant capital and gives investors the opportunity to get in on the ground floor for significant profit potential.
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