Initial Public Offering (IPO)

A milestone for any company is the issuance of publicly traded stock. While the motivations for an initial public offering are straightforward, the mechanism for doing so is complex.  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.

Select an investment bank

When a company wishes to make a public offering, its first step is to select an investment bank to advise it and to perform underwriting functions in connection with the issue. The selection process relies on the investment banker’s general reputation and expertise as well as on the quality of its research coverage in the company’s specific industry. The selection also depends on whether the issuer would like to see its securities held more by individuals or by institutional investors (i.e., the investment bank’s distribution expertise). Prior banking relationships the issuer and members of its board (especially the venture capitalists) have with specific firms in the investment banking community also influence the selection outcome. Often, the selection process is a two-way affair, with the reputable investment banker choosing its clients at least as carefully as the company should choose the investment banker.

Underwriter or Book-running manager

The most common type of underwriting arrangement involved with large issues is the “firm commitment” underwriting. In firm commitment underwriting, the underwriter purchases the entire issue of securities from the issuer and then attempts to resell the securities to the public. The difference between the price at which the underwriter buys and subsequently sells the issue is called the gross spread.

Public offerings can be managed by one underwriter (sole managed) or by multiple mangers. When there are multiple managers, one investment bank is selected as the lead or book-running manager. The lead manager almost always appears on the left of the cover of the prospectus, and it plays the major role throughout the transaction. The managing underwriter makes all the arrangements with the issuer, establishes the schedule of the issue, and has primary responsibility for the due diligence process, pricing and distribution of the stock. The lead manager is also responsible for assembling a group of underwriters (the syndicate) to assist in the sale of the shares to the public. Members of the syndicate are paid a portion of the gross spread for their participation.

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.

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.

Selling Concession

The lead underwriter, the co-managers and the syndicate members all receive compensation from the company for being involved in the IPO process. This compensation comes from the gross spread—the difference between the price the securities are bought from the issuer, and the price for which they are delivered to the public. The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread. The second portion of the spread is called the “selling concession”, and it is the amount paid to the underwriter and other syndicate members for actually selling the securities. This is typically equal to 60% of the gross spread. Each syndicate member receives a selling concession based on the amount of the issue it sells to its customers. Institutions occasionally directly designate the selling concession credit associated with their stock purchase to a specific syndicate member regardless of who actually sold the stock.

The Securities Act of 1933 mandates that the company and its counsel draft a registration statement for filing with the SEC, based upon an outline frequently provided by the lead underwriter. It usually takes several weeks and many meetings of the working group (the company management, its counsel and auditors, the underwriters, the underwriters’ counsel and accountants) before the registration statement is ready to file. The registration statement is circumscribed by Section 5 of the Act, which gives specific requirements for the registration statement. The registration statement consists of two parts: the prospectus, which must be furnished to every purchaser of the securities, and “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC.

Due diligence

The underwriter has a “due diligence” requirement to investigate the company and verify the information it provides about the company to investors. The Securities Act also makes it illegal to offer or sell securities to the public unless they have first been registered.

Once the registration statement is approved by the SEC, the marketing of the offering begins. Often the Red Herring is sent to sales people as well as to institutional investors around the country. At the same time, the company and the underwriter promote the IPO through the road show, in which the company officers make numerous presentations to (mainly) institutional investors. A typical road show lasts 3-4 weeks and includes two or more meetings a day with both retail salespeople and institutional investors.

As IPO progresses, the underwriter receives indications of interest from investors. The indications of interest by individual investors and by institutions differ along several dimensions. First, retail investors typically submit a “market order” in which only the quantity desired is stated. Institutions, on the other hand, typically submit limit orders where the quantity demanded is subject to a maximum price. Second, retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders. Third, in some cases, institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled. These differences in turn may affect the investment bank marketing strategy. However, regardless of the source of the indication of interest, at this stage, prior to the effective day, no shares can be officially sold, so any orders submitted are only indications of interest and are not legally binding.

On the day prior to the effective date, after the market closes, the firm and the lead underwriter meet to discuss two final (and very important) details: the offer price and the exact number of shares to be sold. Particular attention during the pricing decision is given to the order books (where institutions and other investors’ indications are recorded). Discussions with investment bankers indicate that they perceive that an offer should be two to three times oversubscribed to create a “good IPO”.

IPO Readiness Assessment

As companies prepare for an IPO, an IPO Readiness assessment can be useful to identify big-picture issues and prevent embarrassing “deal killer” surprises late in the process. The right amount of preparation also helps companies establish a timetable based on the offering’s strategic objectives, specific business issues, and the actual work that needs to be performed. Such an assessment provides a reasonable basis for discussions with stakeholders about timing.

A robust IPO Readiness assessment evaluates the effort required to prepare the registration statement and determine what information is most important to investors. During this Going Public phase, the company creates a timeline for the offer pricing and closing to illustrate how and when the IPO will be completed.

Biggest IPOs to date

• Visa Inc., $17.86 billion
• ENEL SpA, $16.45 billion
• Facebook, $16.00 billion
• General Motors, $15.77 billion
• Kraft Foods, $8.68 billion
• United Parcel Service (UPS), $5.47 billion
• CIT Group Inc., $4.60 billion
• The Travelers Companies, Inc., $3.88 billion
• HCA Holdings, Inc, $3.79 billion
• The Goldman Sachs Group, $3.66 billion
• People’s United Financial Inc., $3.44 billion
• Charter Communications Inc., $3.23 billion
• Prudential Financial, Inc., $3.03 billion
• MetLife, Inc., $2.88 billion
• Kinder Morgan, Inc, $2.86 billion
• Genworth Financial Inc, $2.83 billion
• Mastercard Incorporated, $2.39 billion
• Agilent Technologies Inc., $2.16 billion
• Verisk Analytics, Inc., $1.88 billion
• Principal Financial Group Inc., $1.85 billion
• Assurant Inc, $1.76 billion
• WellPoint Inc., $1.73 billion
• Google Inc., $1.67 billion
• Spirit AeroSystems Holdings Inc, $1.43 billion
• USEC Inc., $1.43 billion
• Huntsman Corporation, $1.39 billion

Terms Used in an IPO

Primary market: The market in which investors have the first opportunity to buy a newly issued security like in an IPO.

Prospectus: A formal legal document describing the details of the company created for a proposed IPO. It is the document that makes investors aware of the risks of an investment.

Green shoe option: It is referred to as an over-allotment option. It is a provision contained in an underwriting agreement whereby the underwriter gets the right to sell investors more shares than originally planned by the issuer in the event that the demand for a security issue proves higher than expected.

Book Building: The process by which an attempt is made to determine at what price the securities to be offered based on demand from investors. An electronic book is being built by accepting orders from the investors who indicate the number of shares they desire and the price they are willing to pay.

Over subscription: A situation in which the demand for shares offered in an IPO exceeds the number of shares issued.

Price band

Price band in the book building process refers to the band within which the investors can bid. The spread between the floor and the cap of the price band is not more than 20%. The only requirement is that the issuing company is required to disclose in detail about the qualitative and quantitative factors justifying the issue price.

Going Public

Going public raises cash, and typically 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.