What is an IPO: how a company goes public?

The dream of every company is to go public. It makes it known, gives it status and, most importantly, provides access to capital. How does the initial public offering and whether investors should invest in the IPO?

Every company seeks to raise capital for the development of its business. At the initial stage, the startup stage, it is difficult for a company to attract a bank loan or find a “good angel” willing to invest in its development. And then the firm issues shares that are offered to investors. Everyone who buys a share in the startup becomes its co-owner.

If the business is successful, the company needs additional capital for further development. Of course, you can take out a loan or issue bonds and promissory notes. But the most profitable variant is to issue shares for trading on the stock exchange. It makes it possible to attract millions of investors and billions of dollars of investments.

The initial public offering, or IPO (Initial Public Offering), is the first public sale of the company’s shares to the public. The company issues the shares and puts them on the stock exchange, and any willing investor or investment fund can buy them. This is a costly process, but if the offering is successful, the company will be able to attract hundreds of thousands, millions, or even billions of dollars.

However, in order to be listed on the stock exchange, a company must have a good business history and prepare transparent reporting for several years. For example, only a company with a provisional value of at least $50 million can place its shares on the New York Stock Exchange.

Once the company has thought about an initial public offering on the stock exchange, the preliminary stage of the IPO begins.

Preliminary stage

The preliminary stage is the longest and can last from several months to several years. During this time, the company must evaluate its business, asset structure and corporate governance. Then you can calculate at what price and how many shares should be issued and, accordingly, determine the future capitalization of the company.

It is also important to assess the degree of financial and informational transparency. This increases investor confidence in the company and enhances its reputation. In addition, the future issuer, according to the rules of stock trading, is obliged to present quarterly financial statements to the public.

Based on the results of the analysis, the company decides whether it is profitable to offer its shares to the public. The board of directors, having weighed up the pros and cons, must make a decision on whether to launch the IPO or not. If the answer is yes, the company signs an agreement with the underwriter – and the next preparatory stage of the IPO begins.

Preparatory phase

All the preparatory work for the IPO is done by the underwriter – usually an investment bank, with which the company enters into an agreement. In addition, the stock exchange, where the shares will be listed, and brokers are chosen.

The underwriter evaluates the company and, taking into account market conditions, determines the parameters of the upcoming IPO: how many shares will be issued and at what initial price, as well as when it is best to release the securities to the stock exchange.

Then the underwriter prepares an investment memorandum for the regulatory authority of the country in which the IPO will take place. In the U.S., the Securities and Exchange Commission (SEC) controls the stock exchanges.

The investment memorandum contains detailed information about the company: information about the management and shareholders, financial statements and dividend policy. The company must also explain why it decided to raise the funds. If the information provided in the memorandum satisfies all the requirements of the regulatory authority, the IPO date is set.

Finally, an advertising campaign is launched to increase investor interest in the securities being offered. Company representatives meet with potential investors and brokers during a trip to major global financial centers such as London, New York, Hong Kong or Tokyo. In such a “road show,” or Road Show, management discloses the company’s performance and offering data to investors. The Road Show usually lasts two to three weeks.

Main stage

Preliminary bids for the issuer’s shares are collected during the Road Show. The major investors obtain the right to purchase the shares before their official offering. Based on the applications collected the underwriter receives the information on the number of shares the investors are ready to buy and at what price. By the way, the underwriter has the preemptive right to buy the shares before the IPO with their further resale after the offering.

The final stage

The final stage, or listing, is the beginning of the circulation of securities on the stock exchange. It is with the beginning of trading on the exchange that it becomes clear exactly how successful the IPO was. If the price of the securities is adequate to the market conditions, the issuer can expect to build a stable reputation on the stock market and increase its capitalization.

How to participate in the IPO of American companies?

Every year there are up to 200 IPOs of American companies. It is a chance for investors to get a good return on their investment. Some companies appreciate significantly after going public.

IPO on the U.S. stock exchange

The procedure is not different from buying shares of companies from other countries. The investor needs access to the exchange, which is provided by a broker.

Brief instructions on how to buy shares in an IPO:

  • Choose a broker and enter into a cooperation agreement with him.
  • Open an account.
  • Fund it with the amount of the investment.
  • Give the broker an order to buy the securities.
  • When the IPO happens, the broker will buy the specified volume of shares (or shares for the specified amount) and will post information about the purchase in the personal account of the investor.

In short, an IPO is an issuer’s IPO for the sale of shares to an unlimited number of people. There are three main stages of the IPO:

  • OTC (Over the Counter) – when transactions between investors take place directly, without the participation of the exchange. The company not only has not announced the IPO, but it is not known when it will do so (for example, SpaceX).
  • Pre-IPO (Premarket) – non-public company plans an IPO on the horizon of one or two years. This stage is mainly for large venture capitalists from $1 million.
  • The IPO itself, when the issuer announces the IPO, after that there is usually no more than a week for filing.

An important point: applications are accepted in money (in the case of foreign companies – in dollars), and according to the distribution results, the investor receives the shares. This is due to the fact that no one knows in advance what price the organizers will set: it is determined by demand.

Is it worth buying shares in the early days of the IPO?

Buying shares in the early days of the IPO is very risky. Private investors do not have exhaustive information about the company. The general public does not know what the company’s financial indicators are – after all, the issuer is obliged to provide its financial statements only after the IPO. In this sense, the purchase of shares during the IPO is more like a lottery.

In addition, share prices are usually subject to strong fluctuations in the first days of the IPO. Therefore, analysts recommend buying the shares only sometime after their placement – when the price of securities has stabilized.

How to evaluate a company before the IPO

As in the case of choosing an ordinary publicly traded stock, we must evaluate the business’s chances for growth in the future:

  • market capitalization of the issuer (since there are no quotes to calculate, is estimated expertly, for this we read analytics);
  • the company’s revenues – we look at the statements on the website or media reports;
  • debt load;
  • the business margin – compare it with the industry average, etc.

In addition to the financials of the issuer itself, the investor should carefully study other details:

  • the reputation of the team conducting the IPO – the bank underwriter and bookrunner (distributes bids and sets the price of shares at the start);
  • how the transfer of shares to the investor is organized;
  • in which depository the securities will be accounted for.
  • If a new project (startup) is launched, the product of which is not yet known to the public, the background (previous experience) of the team, feedback in the media and on social networks should be studied.

What risks does the investor face when participating in the IPO?

Here are the most obvious risks of the initial public offering:

  • The price can go down for a long time (sometimes a very long time). Examples are well known: Facebook, Twitter, Uber, Lift.
  • The IPO may be postponed or fail to take place at all. It is not such a rare case, the recent example is WeWork.
  • Large participation fee will not pay off with the growth of the share price;
  • If there is a lock-up, the investor is bound by this restriction, most often for three months.

How do I protect myself from the risks of participating in an IPO?

First of all, do not allocate a critical share of capital to this direction. If the amount of investment and the minimum entry threshold allow, no one has done away with diversification. Do not limit your participation in one or two IPOs, spread your investments.

For those who don’t want to take risks or aren’t confident in their experience, ETF funds that track indices of companies going public have been invented. An example is the First Trust US IPO Index Fund (FPX). It allows you to “spread” risk across a hundred issuers that went public less than 1,000 days ago. True, it’s not as interesting in terms of yield as point investments. The fund’s commission is 0.6%, which is quite high for the ETF market.

What is an allocation?

Allocation is a percentage of the amount of your order, which the broker allocates to you, returning the rest to your account. IPO organizers are primarily interested in large sums of money, on which they can earn good money with the least transaction costs. Retail investors are not that interesting for them, at best they are an additional resource for mass publicity of the forthcoming IPO (Road Show). Therefore, large institutional investors – banks, funds, investment companies – have a much better chance of having their bid satisfied.

There may be three options in distribution. You will see the result in your personal cabinet on the brokerage website:

  1. Your application is granted in full. It is unlikely, and you should not be too happy about such an outcome. It means low demand from large institutional investors.
  2. Partially successful – this is the most likely scenario. The average allocations on the market are around 30%;
  3. Your application is rejected: either you have done something wrong, or there were some restrictions in the allocation of applications.

Participating in an IPO is an interesting opportunity to make money on the growth of stocks when companies are listed on the stock exchange. But given the high risks, a general recommendation: do not allocate more than 5-10% of your portfolio to this direction. For newcomers, there is an option to buy shares already on the secondary market on the first day of trading. With a successful IPO, quotations after that also increase, though profits will be a bit lower. The main advantage, in this case, is the absence of lock-up, which reduces the risk of getting stuck in the stock or avoiding the high costs of an early sale. But no one guarantees that in the future the securities won’t fall below the offering price and won’t stay in this range for a long time.

Kevin Doran

I have been trading forex since 2015. Over the past few years, I have tried and tested all the most popular Forex Brokers. I publish my reviews to help you choose a reliable broker and reduce your risks.

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