Initial Public Offerings: Definition and the Process
IPO is the process followed by private companies to offer shares for the first time. IPO is used to raise equity capital from public investors that can benefit the business.
The origin of IPOs dates back to the early 1600s when the Dutch East India Company offered shares for the first time to the public. The NYSE, established in 1792, started with IPOs from the Bank of New York and the First Bank of the United States.
There was an evolution during the 20th century when the stock exchange started growing along with various communication technologies such as the stock ticker telegraph, telephone, and the internet.
IBM was one of the first technology companies to offer IPOs in 1911 when the company started selling business machines. The 1980s saw a boom in IPO offerings in the world of technology, as companies like Microsoft and Oracle stepped into the picture.
Now, why is IPO important? Does it add any value to companies?
Significance of IPOs in the Private Sector
The transition from private to public is a major one for all companies. IPO is the first step that helps private companies make the transition, and it is one of the biggest achievements for companies.
Going public creates opportunities for better visibility and opens many options to get more capital for smooth operations. Offering an IPO is not only about deciding a price for shares and submitting an application to the country's stock exchange. There's a lot more to it.
In the following section, we will examine the steps private companies must follow to offer IPOs.
Steps in the IPO Process
The first step in the IPO process is to select an investment bank that can share the necessary advice and provide underwriting services. Private companies have a lot to work on before they decide to offer IPOs. Selecting an investment bank is not an easy affair. You need to check these points before you zero in on an investment bank:
- The reputation of the bank
- The quality of research
- Industry experience
- Prior relationship with investment bank
Private companies need to be careful when choosing an investment bank. It is necessary to choose one that can help them with the process and share correct suggestions to move forward with the process.
Diligence and regulatory filings
Private companies need to understand and follow the rules and regulations to issue an IPO. Underwriting plays a major role in the overall process. In this process, the investment bank takes up the responsibility to guide the issuing company in selling the initial set of shares to the public. The bank acts as a broker between the company and public investors and makes these underwriting arrangements available to the company:
- Firm commitment
- Best efforts agreement
- All or none agreement
- Syndicate of underwriters
The bank is also responsible for preparing the necessary documents, such as:
- Engagement letter
- Letter of intent
- Underwriting agreement
- Registration statement
- Red herring document
Companies must also know about the various documents and ask the investment bank to get things done properly.
The most important part of the IPO process is setting the price of shares. In the previous steps, the investment bank works to get everything done and get the IPO approved by the authorities. So, once the IPO is approved, the companies must work hand-in-hand with the investment bank to set their price and the number of shares the company will sell. Here are a few factors that affect the pricing of shares:
- The success or failure of roadshows
- The company’s goal
- Present market economy condition
To make sure the shares sell, the companies determine a low price for the shares. Private companies have the target to sell the shares first, even if it means that they are not receiving the full value. Also, if the prices are low, the companies expect an increase in price in the future.
Issuing shares might sound easy when you compare them with the results after the issue is done. The investment bank has to take the responsibility to share analyst recommendations and work on after-market stabilisations, and also promote the shares to create a market.
In case there's an imbalance, the underwriter, i.e. the investment bank, buys shares at the offering price or lower to stabilise the market. These can run for a shorter period of time, and during this time, the bank has the freedom to trade and influence the share price as there are no restrictions on price manipulation during this period.
Transition to market competition
The transition to market competition is a major one, and the time interval for this transition depends on the authorities of the country the company is trading in. The companies make decisions based on market forces instead of relying on mandated disclosures. It is the last and one of the major steps in the IPO process. As the company enters stiff competition, the underwriter takes up the role of advisor and evaluator for the company.
Many companies fail to make it big in the share market, but some have surpassed all expectations and earned the trust of public investors. This is exactly why IPOs are considered to be one of the significant steps for any private company.