Initial Public Offering: How Does It Work?
As a company grows, sometimes it needs more help than what it has received from personal associates or professional venture capitalists.
Most corporations begin as private entities, owned by single or multiple parties. This usually includes the founders of the company, as well as any personal or professional investment partners. To gain more capital, an IPO can be the right solution.
A company may choose to open its shares to the public, allowing public investors to buy different stocks, giving them ownership in the company. This is known as an initial public offering, or IPO.
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The Pros of IPO
An IPO is a sign of growth for a company; it usually means that a company is ready for the next level but needs the extra capital to grow and expand.
There are many other benefits that may come with an IPO.
- New investors can make a fortune.
An IPO is a tool used to grow and strengthen a company, which means it is the perfect time for investors to come in at the ground level while prices are still low. If it is a good investment, the company will increase in value with handsome rewards for all those who invested.
- Employees can benefit, too.
It can be a particularly advantageous arrangement for employees who now have the ability to buy stock options in the company. As they work to improve a
company’s profitability, they can directly and financially benefit from their hard work as the company’s value grows and their shares increase.
- Your company can now afford that merger.
Some companies also use an IPO as a way to pay for a merger. A company may not be liquid enough to buy into a merger with cash, so a joint venture agreement for the company may be another solution to settle the debt.
- Your company is NYSE-listed.
The Cons of IPO
Not all IPOs are a good investment, however, so you must do your due diligence in making sure that this is the right financial strategy for you.
There can be several drawbacks for investors.
- The future is uncertain.
An IPO is a time of great instability for a company with several fundamental shifts in operations and logistics. As more parties come onboard, there can be changes to the company’s structure or leadership that could severely impact the future outlook. For investors, this may mean cheap shares, but there is also less security for those initial investments.
- Investment banks are pricey.
To file an IPO, you need an investment bank to oversee the preparations. Many companies choose world-renowned firms such as Morgan Stanley and Wells Fargo to guide the process, but this comes at an exorbitant fee that will dip into your earnings.
- Owners can’t just buy everything.
Owners may also be limited in how they can set up the IPO. Some companies limit the number of shares, if any, that owners can take; there may be concerns about large chunks of shares in owners’ hands affecting the company’s overall stability prior to the IPO.
- The owner is no longer the boss.
Oftentimes with an IPO, the owner of the company no longer has sole control over a company. The board of directors assumes control and has the power to manage or even fire the owner of the business.
- The new rules are stringent.
Investment banks are needed because of how detailed and strict the regulations are for an IPO. The SEC will examine every facet of your company to ensure that you meet a number of specific requirements.
- Your company secrets are no longer secret.
An IPO brings mass exposure and enormous public interest to a company. With that kind of scrutiny, the inner workings of your company could be exposed, and your competitors can take notice.
- The company will change.
Between shareholders, investment firms, and the NYSE, an IPO introduces several factors that will significantly alter the setup of your company. The board of directors can also leverage greater control in key business decisions, showing inconsistency and liability to potential investors and the public.
Alternatives and Variants
There are also alternatives to an IPO. A direct listing is similar to an IPO, but it is a much shorter and cheaper process because the company only sells shares it already has. Because there are no new shares to create, you can forgo the services of an underwriter and investment bank, saving yourself a ton of money and greatly expediting the entire process.
A Dutch auction is more of a variant of an IPO. It follows many of the same processes but does not set the share price until all bids have been submitted. Bidders are responsible for not only bidding on quantity, but they set their own price, too.
Another approach to a Dutch auction is for the company to set a price but continue to lower that price until it receives a bid. The first bid received results in an automatic sale.
The Dutch have long been thought to be the creators of the original IPO with the Dutch East India Company, so it’s no wonder they are still such a strong influence today.
How Companies Prepare for an IPO
To prepare for an IPO, there are many steps a company must take. It isn’t an easy process, nor can it be done overnight.
The Corporate Finance Institute outlines several steps a company must take.
1. Secure an underwriter and investment bank.
Your investment bank will serve as your underwriter. It will prepare an underwriting agreement that outlines the specific terms of your arrangement, to include the total financial amount the company needs, what stocks will be sold, and how those stocks will be marketed and sold to accomplish that goal.
Before you choose an investment bank, be sure to collect and review proposals from several banks. The investment bank you choose will play a massive role in your IPO by ensuring that you remain on the right track, so it’s important to pick the right one for you. Your investment bank partner needs to have the experience and ability to successfully guide your IPO.
2. Complete due diligence.
About three months before the IPO, it comes time for you to begin your preparations. This process is designed to increase revenue while offloading unprofitable assets in order to make the company look more appealing to new investors.
To do this, you will need to meet with your entire team, including the board of directors and investment bank. You will also require the services of other professionals like your accountant and lawyer, in addition to marketing, public relations, and IT or search engine optimization (SEO) professionals.
3. Begin the valuation process.
When you are ready to file, your investment bank will need to submit an S-1 registration statement. This serves as your official IPO proposal and includes an in-depth report of the entire company with key IPO details, such as what you will be selling, at what price, and what the funds will be used for. Your proposal must also include financial statements, management listings, and full disclosure of any previous or pending litigation.
The Securities and Exchange Commission is an instrumental part of the process, serving in a regulatory capacity to oversee the creation and execution of a company’s IPO. They will review your S-1 statement and conduct an investigation to ensure that the information you submitted is accurate and true.
If you successfully pass the investigation, you will then need to finalize the details of your IPO with the SEC. This includes setting a date so the final preparations can begin.
4. File a prospectus and prepare for audit.
The prospectus is like an internal press release that provides a detailed analysis of your company’s background and current standing. All financial information should be provided, including at least three years of financial statements.
Based upon your prospectus, investors can make bids that include how many shares they would like to buy and at what price. You will need to compile your accepted bids into a proposal that is then reviewed by auditors.
Before you can go public, you need to formally join either the NYSE or NASDAQ, whichever stock exchange will be hosting your IPO.
5. Prepare for opening day.
To generate interest in your IPO, you will need to publish a press release introducing your company to the public. This notice should include the shares for sale and their price so potential investors can determine the risk potential of investing.
Those who submit bids are notified the day before opening day with the total shares that they can buy.
Once a company’s preparation is complete, it is time for the IPO to go live. Opening day is often signified by the founders and management ringing the bell for NYSE or NASDAQ.
This is done through a few steps:
1. The IPO goes live.
When the IPO launches, the quiet period begins. This is where the underwriter takes center stage, tasked with securing a market for all of the stock that was sold. This quiet period usually lasts about 25 days, during which the company is focused on remaining stable and consistent.
2. Earnings are estimated.
After the completion of the quiet period, the underwriters begin to determine earnings. They use the data accumulated during this period to calculate estimated company earnings. This helps investors adapt to this new investment environment and learn how to determine their own earnings in the future.
3. Investor sales open at six months.
There is a minimum six-month ownership period for any shares sold during the IPO. This is to avoid further instability during a time of great internal change for a company. The SEC also allows for the public resale of restricted securities through Rule 144 if certain exemptions are met.
An IPO can be a response to an economic recession or depression, marking either an upward or downward trend depending on the market and what the company is trying to achieve. 2008’s economic recession made history with the least amount of IPOs.
Most companies prepare for an IPO when they achieve unicorn status, or when a company reaches $1 billion private valuation. This is not a requirement, however; many companies may proceed with an IPO if they show great potential for future profits.
With the extra help that investor capital provides, companies can grow and achieve their ultimate potential with high future earnings.
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