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Initial Public Offering (IPO)?

An Initial Public offering (IPO)
The process of offering shares of a private corporation to the public in a new
stock issuance.
Public share issuance allows a company to raise capital from public investors.
The transition from a private to a public company can be an important time for
private investors to fully realize gains from their investment as it typically
includes share premiums for current private investors.
It also allows public investors to participate in the offering.

KEY TAKEAWAYS
• An initial public offering (IPO) refers to the process of offering shares of a
private corporation to the public in a new stock issuance.
• Companies must meet requirements by The Securities and Exchange Board of
India (SEBI) to hold an initial public offering (IPO).
• IPOs provide companies with an opportunity to obtain capital by offering
shares through the primary market.
• Companies hire investment banks to market, gauge demand, set the IPO price
and date, and more.
• An IPO can be seen as an exit strategy for the company’s founders and early
investors, realizing the full profit from their private investment.

How an Initial Public Offering (IPO) Works?

Prior to an IPO, a company is considered private. As a private company, the
business has grown with small number of shareholders including early investors
like the founders, family, and friends along with professional investors such as
venture capitalists or angel investors.
When a company reaches a stage in its growth process where it believes it is
mature enough for the rigors of SEBI regulations along with the benefits and
responsibilities to public shareholders, it will begin to advertise its interest in
going public.
However, private companies at various valuations with strong fundamentals and
proven profitability potential can also qualify for an IPO, depending on the
market competition and their ability to meet listing requirements.
An IPO is a big step for a company as it provides the company with access to
raising a lot of money. This gives the company a greater ability to grow and
expand.
IPO shares of a company are priced through underwriting due diligence.

When a company goes public, the previously owned private share ownership
converts to public ownership, and the existing private shareholders’ shares
become worth the public trading price.
Share underwriting can also include special provisions for private to public share
ownership. Generally, the transition from private to public is a key time for
private investors to cash in and earn the returns they were expecting. Private
shareholders may hold onto their shares in the public market or sell a portion or
all of them for gains.
Meanwhile, the public market opens up a huge opportunity for millions of
investors to buy shares in the company and contribute capital to a company’s
shareholders' equity. The public consists of any individual or institutional
investor who is interested in investing in the company.
Overall, the number of shares the company sells and the price for which shares
sell are the generating factors for the company’s new shareholders' equity value.
Shareholders' equity still represents shares owned by investors when it is both

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private and public, but with an IPO the shareholders' equity increases
significantly with cash from the primary issuance.

History of Initial Public Offerings (IPOs)

The term initial public offering (IPO) has been a buzzword on Wall Street and
among investors for decades. The Dutch are credited with conducting the first
modern IPO by offering shares of the Dutch East India Company to the general
public. Since then, IPOs have been used as a way for companies to raise capital
from public investors through the issuance of public share ownership.
Through the years, IPOs have been known for uptrends and downtrends in
issuance. Individual sectors also experience uptrends and downtrends in
issuance due to innovation and various other economic factors. Tech IPOs
multiplied at the height of the dot-com boom as startups without revenues
rushed to list themselves on the stock market.
The 2008 financial crisis resulted in a year with the least number of IPOs. After
the recession following the 2008 financial crisis, IPOs ground to a halt, and for
some years after, new listings were rare. More recently, much of the IPO buzz
has moved to a focus on so-called unicorns; startup companies that have reached
private valuations of more than $1 billion.

Underwriters and the Initial Public Offering (IPO) Process

An IPO comprehensively consists of two parts. The first is the pre-marketing
phase of the offering, while the second is the initial public offering itself. When
a company is interested in an IPO, it will advertise to underwriters by soliciting
private bids or it can also make a public statement to generate interest.
The underwriters lead the IPO process and are chosen by the company. A
company may choose one or several underwriters to manage different parts of
the IPO process collaboratively. The underwriters are involved in every aspect of
the IPO due diligence, document preparation, filing, marketing, and issuance.

Steps to an IPO include the following:

1. Underwriters present proposals and valuations discussing their services, the
best type of security to issue, offering price, amount of shares, and estimated
time frame for the market offering.
2. The company chooses its underwriters and formally agrees to underwriting
terms through an underwriting agreement.
3. IPO teams are formed comprising underwriters, lawyers, certified public
accountants (CPAs), and SEBI experts.
4. Information regarding the company is compiled for required IPO
documentation.
a. The Registration Statement is the primary IPO filing document. It has two
parts: The prospectus and the privately held filing information. It includes
preliminary information about the expected date of the filing. It will be revised
often throughout the pre-IPO process. The included prospectus is also revised
continuously.

5. Marketing materials are created for pre-marketing of the new stock issuance.
a. Underwriters and executives market the share issuance to estimate demand
and establish a final offering price. Underwriters can make revisions to their
financial analysis throughout the marketing process. This can include changing
the IPO price or issuance date as they see fit.
b. Companies take the necessary steps to meet specific public share offering
requirements. Companies must adhere to both exchange listing requirements
and SEC requirements for public companies.
6. Form a board of directors.
7. Ensure processes for reporting auditable financial and accounting information
every quarter.

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8. The company issues its shares on an IPO date.

a. Capital from the primary issuance to shareholders is received as cash and
recorded as stockholders' equity on the balance sheet. Subsequently, the balance
sheet share value becomes dependent on the company’s stockholders' equity per
share valuation comprehensively.
9. Some post-IPO provisions may be instituted.
a. Underwriters may have a specified time frame to buy an additional amount of
shares after the initial public offering (IPO) date.
b. Certain investors may be subject to quiet periods.

Corporate Finance Advantages of an IPO

The primary objective of an IPO is to raise capital for a business. It can also come
with other advantages.
• The company gets access to investment from the entire investing public to raise
capital.
•Facilitates easier acquisition deals (share conversions). Can also be easier to
establish the value of an acquisition target if it has publicly listed shares.
• Increased transparency that comes with required quarterly reporting can
usually help a company receive more favorable credit borrowing terms than as a
private company.
• A public company can raise additional funds in the future through secondary
offerings because it already has access to the public markets through the IPO.
• Public companies can attract and retain better management and skilled
employees through liquid stock equity participation (e.g. ESOPs). Many
companies will compensate executives or other employees through stock
compensation at the IPO.
• IPOs can give a company a lower cost of capital for both equity and debt.
• Increase the company’s exposure, prestige, and public image, which can help
the company’s sales and profits.

Initial Public Offering (IPO) Disadvantages & Alternatives

Companies may confront several disadvantages to going public and potentially
choose alternative strategies. Some of the major disadvantages include the
following:
• An IPO is expensive, and the costs of maintaining a public company are ongoing
and usually unrelated to the other costs of doing business.
• The company becomes required to disclose financial, accounting, tax, and other
business information. During these disclosures, it may have to publicly reveal
secrets and business methods that could help competitors.
• Significant legal, accounting, and marketing costs arise, many of which are
ongoing.
• Increased time, effort, and attention required of management for reporting.
• The risk that required funding will not be raised if the market does not accept
the IPO price.

• There is a loss of control and stronger agency problems due to new

shareholders who obtain voting rights and can effectively control company
decisions via the board of directors.
• There is an increased risk of legal or regulatory issues, such as private
securities class action lawsuits and shareholder actions.
• Fluctuations in a company's share price can be a distraction for management
which may be compensated and evaluated based on stock performance rather
than real financial results.
• Strategies used to inflate the value of a public company's shares, such as using
excessive debt to buy back stock, can increase the risk and instability in the firm.

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• Rigid leadership and governance by the board of directors can make it more
difficult to retain good managers willing to take risks.

Investing in an Initial Public Offering (IPO)

When a company decides to raise money via an IPO it is only after careful
consideration and analysis that this particular exit strategy will maximize the
returns of early investors and raise the most capital for the business.
Therefore, when the IPO decision is reached, the prospects for future growth are
likely to be high, and many public investors will line up to get their hands on
some shares for the first time.
IPOs are usually discounted to ensure sales, which makes them even more
attractive, especially when they generate a lot of buyers from the primary
issuance.
The IPO price is based on the valuation of the company using fundamental
techniques. The most common technique used is discounted cash flow, which is
the net present value of the company’s expected future cash flows.

Performance of an Initial Public Offering (IPO)

There are several factors that may affect the return from an IPO which is often
closely watched by investors. Some IPOs may be overly-hyped by investment
banks which can lead to initial losses. However, the majority of IPOs are known
for gaining in short-term trading as they become introduced to the public. There
are a few key considerations for IPO performance.
Lock-Up
If you look at the charts following many IPOs, you'll notice that after a few
months the stock takes a steep downturn. This is often because of the expiration
of the lock-up period. When a company goes public, the underwriters make
company insiders such as officials and employees sign a lock-up agreement.

Lock-up agreements are legally binding contracts between the underwriters and
insiders of the company, prohibiting them from selling any shares of stock for a

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specified period of time. The period can range anywhere from three to 24 months.
The problem is, when lockups expire, all the insiders are permitted to sell their
stock. The result is a rush of people trying to sell their stock to realize their profit.
This excess supply can put severe downward pressure on the stock price.

Waiting Periods
Some investment banks include waiting periods in their offering terms. This sets
aside some shares for purchase after a specific period of time. The price may
increase if this allocation is bought by the underwriters and decrease if not.
Flipping
Flipping is the practice of reselling an IPO stock in the first few days to earn a
quick profit. It is common when the stock is discounted and soars on its first day
of trading.

IPOs Over the Long-Term

IPOs are known for having volatile opening day returns that can attract investors
looking to benefit from the discounts involved. Over the long-term, an IPO's price
will settle into a steady value, which can be followed by traditional stock price
metrics like moving averages. Investors who like the IPO opportunity but may
not want to take the individual stock risk may look into managed funds focused
on IPO universes.

Related Terms
Primary Offering
A primary offering is the first issuance of stock from a private company for public
sale and takes place during an initial public offering (IPO).
more
Introduction to Public Offering Price (POP)
The public offering price (POP) is the price an underwriter sets for new issues of
stock sold to the public during an initial public offering (IPO).
more

Direct Public Offering (DPO)

A direct public offering (DPO) is an offering where the company offers its
securities directly to the public without financial intermediaries.
more
Book Building Definition
Book building is the process by which an underwriter attempts to determine the
price at which an initial public offering (IPO) will be offered.
more

Flotation
Flotation is the process of changing a private company into a public company by
issuing shares and encouraging the public to purchase them.
more
Oversubscribed
Oversubscribed is when the demand for an IPO or other new issue of securities
exceeds the supply being sold.
more