Initial Public Offering (IPO)
An initial public offering (IPO) is the process of offering shares of a private company to the public in a new stock issuance. By this method, a company is allowed to raise capital from public investors.
In the following five steps, the IPO process takes place.
Step 1: Selection of Lead Investment Bank
The first step to initiate the process of the public offering is to select a lead investment bank by the owners of the company. This step takes place six months before the IPO process starts. Applicant banks submit bids that show how much the IPO will raise capital and the bank’s fees. The company selects the bank from a number of applicants based on its reputation and its expertise in the company’s industry.
The company usually wants a bank that is able to sell the shares to as many banks, institutional investors, or individuals as possible. It’s the responsibility of the bank to put together all the buyers.
The selected bank usually charges a fee that ranges in between 3% and 7% of the total sales price of IPO.
This whole process of an investment bank handling an IPO is called underwriting. An underwriting agreement is signed between the company and its investment upon selection in which detailed explanation regarding the amount of money to be raised, the type of securities which will be issued, and all fees is written for the understanding of both the parties.
Through this agreement, the bank ensures that the company successfully issues the IPO and that the shares get sold at a certain price.
Step 2: Due Diligence
The second step of the IPO process is due diligence which takes a lot of time in the whole procedure because there is a huge amount of paperwork that both the company and underwriters have to do.
The issuing company needs to register itself with the Security Exchange Commission (SEC) after which the company and the underwriter can make any of the following agreements.
- Commitment With Firm Agreement. This is an agreement that states that the underwriter will purchase all shares from the issuing company and then it will resell them to the public.
- Best Efforts Agreement. Under this agreement, the underwriter does not guarantee an amount of money but will sell the shares at the stake of the issuing company.
- Syndicate of Underwriters: Sometimes IPOs come with huge risks, and the bank doesn’t want all of it. In this type of case, a group of banks comes together under the leading bank to form an alliance that allows each bank to sell part of the IPO and diversifying the risk.
- Engagement Letter: There are two parts of an engagement letter:
- The reimbursement clause expresses that the issuing company will cover the underwriter’s out-of-pocket expenses.
- The gross spread, also termed as the underwriting discount, is generally used to pay the underwriter’s fee and other expenses which are measured by taking the difference of the price paid for buying the share and getting on sale of these shares. The process can be better understood if thinking it as a wholesale business since here the underwriter is also willing to purchase all of the shares at a discounted rate.
For example, there are 2,000 shares each priced at $20. The underwriter purchases them for $18 per share, spending $36,000and then he trades these securities in the market at $20 value, making it $40,000. That’s a gross spread of $4,000.
- Letter of Intent: The letter has three parts.
- The commitment of underwriter to the company.
- Agreement of the company to provide all information and cooperate
- Agreement of the company to offer underwriter a 15% over-allotment option.
- Red Herring Document: Except for the details regarding price and number of shares, this preliminary prospectus includes all the information about the company’s operations and prospects.
- Underwriting Agreement: The underwriter is legally bound to purchase the shares at the agreed-upon price once the price of shares is determined.
- S-1 Registration Statement. This is needed to be submitted to the SEC. There are two parts:
- Information that is required in the prospectus: The prospectus is a legal document that is provided to everyone who is interested in buying the stock so it is extremely important and necessary to mention the business operations of the company, audited financial statements, and other relevant information of the company in the prospectus.
- Information that is not required in the prospectus: It includes extra information that the company does not want to share with the investors but is required to file with the SEC.
Step 3: Pricing
The third step in the IPO process is pricing which depends on the value of the company. It impacted by the success of the roadshows and the condition of the market and economy.
Once the SEC approves the offering, it will work with the company to determine a date for the IPO process to take place. The underwriter is required to put together a prospectus that contains all financial information on the company which is then circulated to the prospective buyers during the roadshow.
The prospectus must include a three-year record of the financial statements. Investors then present bids showing how many shares they are interested in buying.
Step 4: Stabilization
Under this fourth step, efforts are made to create a market for the stock after its issuance and to ensure that plenty of buyers are there so that price of the stock remains at a reasonable level. This step lasts for 25 days during the “quiet period.”
Step 5: Transition
Once the quiet period ceases 25 days after the IPO, the fifth step is the transition to market competition initiates. The underwriters provide their judgment about the company’s earnings. Now both the underwriter and investors transit from relying on the prospectus and move towards looking at the market.
After the completion of the abovementioned steps, all information comes in front of the public, they know everything about the company and out from the hands of the underwriter, however, they can provide the company with the figures on the company’s earnings and post-IPO valuation. Six months after the process of IPO, inside investors have the right and are free to sell their shares.