An initial public stock offering (IPO) referred to simply as an “offering” or “flotation,” is when a company (called theissuer) issues common stock or shares to the public for the first time. They are often issued by smaller, younger companies seeking capital to expand, but can also be done by large privately-owned companies looking to become publicly traded.
Common stock is a form of corporate equity ownership, a type of security. It is called “common” to distinguish it from preferred stock. Preferred stock is a special equity security that resembles properties of both equity and a debt instrument and generally considered a hybrid instrument. In the event of bankruptcy, common stock investors receive their funds after preferred holders, bondholders, creditors, etc. On the other hand, common shares on average perform better than preferred shares or bonds over time.
In financial markets, a share is a unit of account for various financial instruments including stocks (ordinary or preferential), and investments in limited partnerships, and REITS..
Common stock is usually voting shares, though not always. Holders of common stock are able to influence the corporation through votes on establishing corporate objectives and policy, stock splits, and electing the company’s board of directors. Some holders of common stock also receive preemptive rights, which enable them to retain their proportional ownership in a company should it issue another stock offering. There is no fixed dividend paid out to common stock holders and so their returns are uncertain, contingent on earnings, company reinvestment, and efficiency of the market to value and sell stock. Additional benefits from common stock include earning dividends and capital appreciation.
In an IPO the issuer may obtain the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), best offering price and time to bring it to market.
An IPO can be a risky investment. For the individual investor, it is tough to predict what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value.
Reasons for listing
When a company lists its shares on a public exchange, it will almost invariably look to issue additional new shares in order at the same time. The money paid by investors for the newly-issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of stock market investors to provide it with large volumes of capital for future growth. The company is never required to repay the capital, but instead the new shareholders have a right to future profits distributed by the company and the right to a capital distribution in case of dissolution.
The existing shareholders will see their shareholdings diluted as a proportion of the company’s shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms.
In addition, once a company is listed, it will be able to issue further shares via a rights issue, thereby again providing itself with capital for expansion without incurring any debt. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list.
Benefits of being a public company-
• Bolster and diversify equity base
• Enable cheaper access to capital
• Exposure and prestige
• Attract and retain the best management and employees
• Facilitate acquisitions
• Create multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc
IPOs generally involve one or more investment banks as “underwriters.” The company offering its shares, called the “issuer,” enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.
The sale (that is, the allocation and pricing) of shares in an IPO may take several forms. Common methods include:
Best efforts contract – In the best efforts contract the underwriter agrees to sell as many shares as possible at the agreed-upon price.
- Firm commitment contract In the firm commitment contract the underwriter guarantees the sale of the issued stock at the agreed-upon price. For the issuer, it is the safest but the most expensive type of the contracts, since the underwriter takes the risk of sale.
- All or none contract Under the all-or-none contract the underwriter agrees either to sell the entire offering or to cancel the deal.
- Bought deal Bought deals are usually priced at a larger discount to market than fully marketed deals, and thus may be easier to sell
- Dutch auction A Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer’s price, or a predetermined reserve price (the seller’s minimum acceptable price) is reached.
- Self distribution of stock
A large IPO is usually underwritten by a “syndicates” of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold (called the gross spread). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases.
Multinational IPOs may have as many as three syndicates to deal with differing legal requirements in both the issuer’s domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements, IPOs typically involve one or more law firms with major practices in securities law.
Usually, the offering will include the issuance of new shares, intended to raise new capital, as well the secondary sale of existing shares. However, certain regulatory restrictions and restrictions imposed by the lead underwriter are often placed on the sale of existing shares.
The underpricing of initial public offerings (IPO) has been well documented in different markets (Ibbotson, 1975; Ritter 1984; Levis, 1990; McGuinness, 1992). While Issuers always try to maximize their issue proceeds, the underpricing of IPOs has constituted a serious anomaly in the literature of financial economics. Many financial economists have developed consequence of deliberate underpricing by issuers or their agents. In general, smaller issues are observed to be underpriced more than large issues (Ritter, 1984, Ritter, 1991, Levis, 1990) Historically, IPOs both globally and in the United States have been underpriced. The effect of “initial underpricing” an IPO is to generate additional interest in the stock when it first becomes publicly traded. Through flipping, this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in “money left on the table”—lost capital that could have been raised for the company had the stock been offered at a higher price. One great example of all these factors at play was seen with theglobe.com IPO which helped fuel the IPO mania of the late 90’s internet era. Underwritten by Bear Steams on November 13, 1998 the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock . Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.
A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building.
Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificates to the clearing agent bank’s custodian, or a delivery versus payment (DVP) arrangement with the selling group brokerage firm.
Investment banks, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the underwriters (“syndicate”) arranging share purchase commitments from leading institutional investors.