Before a private company can make its shares available to the public for investment, it first has to go through the initial public offering (IPO) process.
An IPO marks the first time individuals other than angel investors or venture capitalists can make investments in a company. Once the initial public offering process is complete, traders can buy or sell shares in the company through a public exchange like the New York Stock Exchange or Nasdaq.
There are different reasons a company may choose to do an IPO, but it’s often used as a means of raising capital. The initial public offer process can also help raise visibility around a particular company’s brand, helping to fuel growth. It means that ownership of the company is transitioning from founders and a few early investors to a much larger group of individuals and organizations.
From an investor standpoint, getting in on the ground floor of a new initial public offering might be appealing if the company you think has the potential to take off. If you’re interested in how to buy IPO stock, this primer explains how the IPO process works step by step.
A Quick Refresher on IPOs
Again, IPO stands for initial public offering. If a company launches an IPO, it means that it’s only had private investors, such as angel investors, up to that point but it’s now ready to let other investors purchase shares. Under federal securities laws, this can’t happen until the company is properly registered with the SEC.
An IPO can help companies raise capital as an alternative to other methods, such as crowdfunding, which involves raising funds from a pool of investors though unlike an IPO, it doesn’t involve the buying or selling of shares in a company.
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How Does the IPO Process Work?
At a glance, the initial public offering process seems relatively simple to understand. A private company makes its shares available to the public for the first time, hence why it’s often referred to as “going public”.
But the initial public offering process is more detailed and complex than that. There are specific steps that have to take place to ensure that an IPO is completed in accordance with Securities and Exchange Commission regulations. The company, either on its own or while working with analysts and investors, must value the company and set an initial public offer.
After completing due diligence, the company can move forward with an IPO announcement and choose an IPO launch date. Investors can then review the IPO prospectus to determine whether they want to invest or not.
The entire IPO process can take six months to a year or even longer to complete. Aside from being time-consuming, it can also be costly, so companies must have some degree of certainty that the IPO will succeed before undertaking it.
7 Steps of the IPO Process
The IPO process takes time, and it’s important for all parties involved that the appropriate steps be followed. If something is missed or overlooked, that could put the success of a company’s initial public offering in jeopardy. Here are the steps they must go through:
1. Choosing an Underwriter
Before starting any of the other IPO process steps, a company first has to connect with a reputable underwriter or group of underwriters. Again, these are investment banks that are registered with the SEC to offer underwriting services.
When choosing an underwriter, companies can consider a variety of factors, including:
• IPO track record
• Research quality
• Industry expertise
• Distribution (i.e. what type of investors the bank will be able to distribute the initial public offering to)
Companies may also weigh any prior relationship they have with a particular investment bank or banks when deciding which one(s) to use for underwriting.
2. Due Diligence
During the due diligence phase, the IPO underwriting team will conduct background research into the company and its upper management. This ensures that there are no surprises prior to or during the IPO launch that could affect share pricing.
At this step in the IPO process, the underwriter and the company will sign necessary contracts specifying the scope of services provided. The contract can take several structures:
• Firm Commitment: In this type of arrangement, the underwriter agrees to purchase the IPO and resell shares to the public. This guarantees that the company receives an agreed-upon amount of money.
• Best Efforts: With this type of agreement, the underwriter assents to selling shares to the best of its ability, though there’s no guarantee that all shares will sell.
• All or None: In an all or none or agreement, all shares of the IPO must be sold or the offering is canceled.
In some cases, a group or syndicate of underwriters can come together to oversee the IPO process and manage risk. Each bank in the syndicate can sign a contract with the company to sell part of the IPO.
The underwriters will also initiate the registration process with the SEC and complete supporting documents for the IPO. These might include:
• Engagement Letter: An engagement letter typically includes a clause stating what expenses the company will reimburse to the underwriter as well as the spread that’s used to pay the underwriter’s fees, typically 7% of proceeds.
• Letter of Intent: This letter outlines the underwriter’s commitment or obligations to the issuing company, the company’s statement of commitment to cooperate with the underwriter and an agreement to provide the underwriter with a 15% over allotment option.
• Underwriting Agreement: The underwriting agreement binds the underwriter to purchase shares from the issuing company at a specified price.
• Red Herring Document: A red herring document contains some of the same information about the IPO that’s included in the IPO prospectus, excluding the price and number of shares being offered.
• S-1 Registration Statement: This is the document that’s submitted to the SEC to register the IPO and it must include relevant information about the company that must be included in the prospectus, as well as additional details that are not made available to the public.
3. SEC Review and Road Show
At this stage of the initial public offering process, the SEC will review all of the documents submitted for the registration. Meanwhile, the company and its underwriting team will prepare for the road show.
This road show is effectively a marketing strategy in which the underwriters attempt to gauge interest in the IPO from institutional investors. This can help underwriters to set the IPO price and determine what number of shares to offer.
4. IPO Pricing
Once the SEC has approved the IPO, the next critical step is choosing an initial share price. In terms of how an IPO price is set, this can depend on a number of factors, including:
• Company valuation
• Anticipated demand for shares among investors
• Road show outcomes
• Market conditions
• How much capital the company hopes to raise
• The company’s reputation
Pricing is important because it can determine the success or failure of an IPO. Price an initial public offer too high and it may scare off investors; price it too low and the company may not reach its target goal for capital raised once shares go on the market.
Once an IPO has the SEC’s approval and the number and price of shares has been set, all that’s left to do is launch. The company or underwriters typically announce ahead of time when an IPO is set to list so interested investors can ready themselves to buy shares on that date.
Stabilization refers to the underwriter taking direct action to stabilize share prices once the IPO launches. This is something underwriters can do during the 25-day window after an initial public offering hits the market, otherwise known as the quiet period.
In essence, the underwriter can execute trades during this period in an effort to influence pricing in favor of the company. Any SEC restrictions against price manipulation are temporarily suspended during this time.
SEC rules do, however, still apply to investors who owned shares before the company went public. Specifically, they’re required to observe the IPO lock-up period rule. This rule prevents them from selling any shares they own in the company for a set time period after the IPO, typically 90 to 180 days. This keeps those investors from dumping their shares prematurely which could affect share prices.
7. Transition to Market Competition
After the initial 25-day period following an IPO launch, the underwriters take their hands off the wheel. Rather than relying on the prospectus to determine valuations, shareholders turn their attention to market movements instead. The underwriter can continue acting in an advisory role but at this point, they can no longer do anything to influence pricing.
What Parties Participate in the IPO Process?
It takes a team to successfully launch an IPO, and each member has a distinct role in the initial public offer process. The company is the star player around which the team revolves around, with senior management typically taking the lead. But an IPO also requires assistance from other professionals. Understanding who is involved and what they do can help with navigating the steps of the IPO process.
One role of an investment banker, also called underwriters, is to effectively oversee and manage the initial public offer process. The underwriting team is responsible for performing some of the most important IPO steps, including:
• Preparing IPO documentation
• Conducting necessary due diligence
• Preparing marketing materials for distribution to investors
• Overseeing the sale of company stock through the IPO
The investment banks serving as underwriters can also help with determining the appropriate valuation of a business as part of the IPO process.
Securities and Exchange Commission [SEC]
Companies must register with the SEC before launching an initial public offering. The SEC must review and accept all documentation the company submits in reference to the IPO prior to shares being sold to the public.
Attorneys and Accountants
Attorneys and accountants work alongside underwriters during the initial public offer process to prepare the required documentation. Legal counsel may draft documents and manage the SEC filing, while accountants may be prepare the financial statements that accompany the SEC registration paperwork.
Going public with an IPO means choosing an exchange through which traders can buy and sell stock. In the United States., this typically means the New York Stock Exchange or the Nasdaq.
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These include both the those, such as venture capitalists, who put money into the company prior to its going public and those who anticipate trading shares once the IPO launches. Both institutional investors, such as hedge funds or mutual funds, and individual retail investors who are interested in owning shares, may participate in an IPO.
When considering IPO investing, be sure to weigh the pros and cons to decide if it aligns with your investment goals.
Photo credit: iStock/TimArbaev
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