What Is An IPO ?
An initial public offering, or IPO, is the first sale of stock by a company to the
public. A company can raise money by issuing either debt or equity. If the company
has never issued equity to the public, it's known as an IPO. Companies fall into
two broad categories, private and public.
A privately held company has fewer shareholders and its owners don't have to disclose
much information about the company. Anybody can go out and incorporate a company,
just put in some money, files the right legal documents and follows the reporting
rules of your jurisdiction. Most small businesses are privately held. But large
companies can be private too. It usually isn't possible to buy shares in a private
company. You can approach the owners about investing, but they're not obligated
to sell you anything. Public companies, on the other hand, have sold at least a
portion of themselves to the public and trade on a stock exchange. This is why doing
an IPO is also referred to as "going public."
Public companies have thousands of shareholders and are subject to strict rules
and regulations. They must have a board of directors and they must report financial
information every quarter. From an investor's standpoint, the most exciting thing
about a public company is that the stock is traded in the open market, like any
other commodity. If you have the cash, you can invest."
Going public raises cash, and usually a lot of it. Being publicly traded also opens
many financial doors:
- Because of the increased scrutiny, public companies can usually get better rates
when they issue debt.
- As long as there is market demand, a public company can always issue more stock.
Thus, mergers and acquisitions are easier to do because stock can be issued as part
of the deal.
- Trading in the open markets means liquidity. This makes it possible to implement
things like employee stock ownership plans, which help to attract top talent.
Being on a major stock exchange carries a considerable amount of prestige. In the
past, only private companies with strong fundamentals could qualify for an IPO and
it wasn't easy to get listed.
Getting In On An IPO
Getting a piece of a hot IPO is very difficult, if not impossible. To understand
why, we need to know how an IPO is done, a process known as underwriting.
When a company wants to go public, the first thing it does is hire an investment
bank. A company could theoretically sell its shares on its own, but realistically,
an investment bank is required. Underwriting is the process of raising money by
either debt or equity (in this case we are referring to equity). You can think of
underwriters as middlemen between companies and the investing public. The company
and the investment bank will first meet to negotiate the deal. Items usually discussed
include the amount of money a company will raise, the type of securities to be issued
and all the details in the underwriting agreement.
The deal can be structured in a variety of ways. For example, in a firm commitment,
the underwriter guarantees that a certain amount will be raised by buying the entire
offer and then reselling to the public. In a best efforts agreement, however, the
underwriter sells securities for the company but doesn't guarantee the amount raised.
Also, investment banks are hesitant to shoulder all the risk of an offering. Instead,
they form a syndicate of underwriters. One underwriter leads the syndicate and the
others sell a part of the issue.
Once all sides agree to a deal, the investment bank puts together a registration
statement to be filed with the SEBI. This document contains information about the
offering as well as company info such as financial statements, management background,
any legal problems, where the money is to be used and insider holdings. Once SEBI
approves the offering, a date (the effective date) is set when the stock will be
offered to the public.
During the cooling off period the underwriter puts together what is known as the
red herring. This is an initial prospectus containing all the information about
the company except for the offer price and the effective date, which aren't known
at that time. With the red herring in hand, the underwriter and company attempt
to hype and build up interest for the issue.
As the effective date approaches, the underwriter and company sit down and decide
on the price. This isn't an easy decision it depends on the company and most importantly
current market conditions. Of course, it's in both parties' interest to get as much
as possible.
Finally, the securities are sold on the stock market and the money is collected
from investors.
Don't Just Jump In
Let's say you do get in on an IPO. Here are a few things to look out for.
No History
It's hard enough to analyze the stock of an established company. An IPO company
is even trickier to analyze since there won't be a lot of historical information.
Your main source of data is the red herring, so make sure you examine this document
carefully. Look for the usual information, but also pay special attention to the
management team and how they plan to use the funds generated from the IPO.
And what about the underwriters ?
Successful IPOs are typically supported by bigger brokerages that have the ability
to promote a new issue well. Be more wary of smaller investment banks because they
may be willing to underwrite any company.
The Lock-Up Period
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 lock-up period.
When a company goes public, the underwriters make promoters and employees in case
ESOP to 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 specified period of time. 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.
IPO Basics : Conclusion
Let's review the basics of an IPO :
- An initial public offering (IPO) is the first sale of stock by a company to the
public.
- Broadly speaking, companies are either private or public. Going public means a company
is switching from private ownership to public ownership.
- Going public raises cash and provides many benefits for a company.
- Getting in on a hot IPO is very difficult, if not impossible.
- The process of underwriting involves raising money from investors by issuing new
securities.
- Companies hire investment banks to underwrite an IPO.
- An IPO company is difficult to analyze because there isn't a lot of historical info.
- Lock-up periods prevent insiders from selling their shares for a certain period
of time. The end of the lockup period can put strong downward pressure on a stock.
- Flipping may get you blacklisted from future offerings.
- Road shows and red herrings are marketing events meant to get as much attention
as possible. Don't get sucked in by the hype.