Funding & Investing

Initial public offering: the process

Published: Oct 2011

A company that wishes to raise capital from a broad base of investors often chooses to list itself on a public exchange. The process whereby a previously private company becomes publicly listed has a number of stages. In this article, we explain how it works.

An initial public offering (IPO) is the inaugural sale of a company’s equity on a public stock exchange. Once a company has made its shares available to the general public, it is said to be ‘publicly listed’ and its stock can be freely traded.

A company must perform a number of steps before it becomes listed and its stock can be bought and sold on a stock market. Here we look at issuing an IPO in one of the most popular destinations for such activity: the US.

Selection of underwriters

Although it is possible for a private company to ‘go public’ by issuing its own shares, this is not the most common method used. More frequently, before the company embarks on an IPO, it enlists the services of an investment bank(s), which underwrites some or all of the stock that is to be sold to the public. A team of lawyers and accountants should also be assembled from the start.

Aside from the details of the underwriting, the investment bank will discuss with the company the amount of money that they are looking to raise from the IPO and the type of securities that the company wishes to issue.

While an IPO is often underwritten by a number of banks (a syndicate), they are typically managed by just the one – the lead bank or book runner. For this reason, it is common practice for a company embarking on a public offering to perform a ‘beauty parade’ of financial institutions with experience of carrying off successful public listings.

During this process, each bank prepares a pitch that demonstrates its experience and expertise in raising capital on public stock markets. The bank’s pitch should include information about how many IPOs it has carried out in the past and in which industries. The bank should also be in a position to describe current conditions on the capital markets. At this stage, it is likely that the bank will also give a preliminary analysis of the company’s stock market valuation.

Once the banks have made their case, one of them will usually be chosen as the lead manager. Some of the others may be retained to act as co-managers, but this depends on the size and scope of the offering. For smaller deals, a company may employ the services of just one manager, while for larger offerings as many as six co-managers may be used.

A public offering is usually structured in one of two ways:

  1. Firm commitment. The underwriter purchases the entire allocation of the stock and resells it on a secondary market. This way the underwriter can guarantee that a certain amount of capital will be raised.
  2. Best efforts. The underwriter sells the company’s stock, but doesn’t guarantee the amount of capital that it will raise.

In a typical IPO, the lead underwriter suggests the price at which the stock will be brought to market. It then takes provisional orders from institutional investors that it uses as a barometer of the stock’s demand. The filing price can be adjusted upward if demand is strong (see ‘Hitting the road’ below). In general, the price at which the company offers its stock is below the market estimate.

Going Dutch

In a Dutch auction, the stock’s price is determined by the investors, each of whom submits the highest price he/she is willing to pay and the number of shares he/she wishes to take at that price.

The highest bidder – or if two investors bid the same price, the earliest – gets first refusal on the shares, which are then allocated to the other bidders from highest to lowest bid.

No matter what the investor bids, the price paid is the lowest that any investor who was allocated shares bid. A Dutch auction takes the investment banks out of the equation and lets the forces of supply and demand set the price.

Google decided to launch its 2004 IPO via Dutch auction.

Getting the green light

Whichever country the IPO is being issued in, there will be regulatory and documentation requirements to be fulfilled before it can go ahead. In the US, a company must have the Securities and Exchange Commission’s (SEC) permission to perform an IPO. It can do this by filing a registration statement (Form S-1) with the SEC. This contains basic facts about the company and its financial history.

Prior to going public, the unlisted company is of course a private entity. As such, the current investors must give their consent in order for the company to pursue the IPO; this is called shareholder approval. Shareholders vote on the proposed issue and if the vote goes in the IPO’s favour, the company can take the next step in becoming publicly listed.

The SEC then investigates the issuing company to ensure that all the relevant information has been disclosed. During this period, the S-1 is made public. This, in fact, becomes the initial prospectus containing all the information relating to the company and its share issue, except for the initial offer price and the date on which the stock will go on sale. It will contain a passage in red stating that the company is not attempting to sell its shares before the registration is approved by the SEC, thus referred to as a ‘red herring’.

Once the SEC approves the offering, a date is set when the stock will be listed on the public stock exchange.

Where to issue

Whilst waiting for the IPO to be approved, the company must choose the exchange on which it wishes its stock to be listed. This is an important decision for a number of reasons, including fees. A typical listing fee on NASDAQ is circa $160,000 dollars (one-time fee). Each exchange will have slightly different listing requirements and information on these can be found on the respective exchange’s website.

The likes of Google, Intel, Microsoft and Apple have traditionally opted for NASDAQ, as the exchange is known for listing technology companies. Today, however, the type of company choosing the NASDAQ is much broader because of its success over the past decade.

Other popular exchanges include NYSE Euronext and the London Stock Exchange. In addition to picking its exchange, the company must also select a trading symbol by which the stock will be referred to on the exchange; this is known as a ‘ticker’. Microsoft, for example, trades under MSFT and Starbucks is SBUX. Others are a little more creative, going for memorable ticker symbols, such as WOOF for animal health care company VCA Antech Inc. Tickers can and do vary between stock exchanges, depending upon availability.

Hitting the road

With the prospectus issued to potential investors, the underwriter and company must drum up interest in the share issuance. They do this by undertaking an IPO ‘road show’, which usually lasts a week or perhaps two. This typically involves giving a presentation to large groups of institutional investors and investment banks in the hope of attracting pre-orders for significant tranches of the stock. Presentations may be given internationally, depending on the size of the IPO.

Once the road show ends, the final prospectus can be printed and distributed to investors. It is then a question of choosing the final offering size and price, based on demand. If the company chooses an IPO stock price that is too low, it is said to ‘leave money on the table’. In this case, the stock’s price will rise quickly once it is traded publicly. On the other hand, if it over-inflates its price, the stock moves in the opposite direction. That can mean investors are suspicious of the company, which in turn could damage its reputation.

It is important, therefore, for companies considering an IPO, to spend time with their investment bank(s) in order to determine the right pricing model. Once this has been agreed on, and investors have had the final prospectus for 48 hours, the IPO can then become effective.

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