What is an Initial Public Offering?

An initial public offering or IPO, as implied in the title, is the first offering of a company’s stock to the public. Many companies start out being privately owned, with the shares of the company owned and controlled by the founder(s) and/or the original investors.

A company generally decides to go public when they wish to expand and diversify their equity base, spreading the ownership of the company through the issuance of common stock. An IPO is how a company allows the public to actively invest in the firm.

Nevertheless, many firms choose to remain private, despite the possible advantages going public might offer.
Going public can also have disadvantages for the owners of a company, such as having to be accountable to a larger number of shareholders, instead of a comparatively smaller group of owners.

In addition to increased scrutiny, taking a company public through an IPO also means the company will incur higher accounting and legal costs on top of exchange listing costs, and might have to make public information which could be useful to its competition.

How A Company goes Public

Generally, a company goes public and offers its shares to the public after being established and making a name for itself as a privately owned company. In order to sell itself to the public, the company must have generated interest by making money or having a brilliant product or idea with enough potential to merit the public’s interest and investment dollars.

The company’s first step to going public is to hire an investment banker to underwrite its shares. Underwriting consists of the process a company uses to raise capital, either through debt, by the underwriting of bonds, or equity, by underwriting shares of stock.

While it is possible for the company to market its own shares, an IPO is almost always underwritten by at least one investment bank. For example, the upcoming Facebook IPO has more than thirty investment bankers who will be selling shares on behalf of the company.

Typically, one large investment bank will get the lion’s share of the IPO, in the case of the upcoming Facebook IPO, Morgan Stanley, J.P. Morgan and Goldman Sachs will be the chief underwriters.

Underwriting Shares

The first thing a company does before the IPO, consists of working out how much money the company needs to raise through the IPO and what type of securities need to be underwritten to raise the cash. The investment banker offers the company two types of structures for the deal: a “firm commitment” structure, where the investment bank guarantees the amount of money raised, buying all the stock and then reselling it to clients; and a “best efforts” structure, where the underwriter agrees to sell the company’s securities but does not guarantee the amount to be raised.

Most IPOs have more than one underwriter, forming a syndicate of underwriters to spread the risk. Once the details of the deal are worked out, a prospectus is issued and distributed to the underwriters’ clients announcing the IPO, with all the pertinent financial information about the company, with the exception of the date and the price of the shares for the IPO.

After hyping the company up with a “dog and pony show” to sell the shares to fund managers, hedge funds and financial institutions, a date and price for the shares to be offered in the IPO is announced.

Who Gets to Buy Shares in an IPO?

Access to shares at the IPO price can only be done through an account with the investment banker. Even having an account, there is no guarantee that you will be able to participate, as only the investment banker’s best clients are generally offered shares.

After the IPO, the shares go on sale to the public on the secondary market, trading on an exchange. If it is a high profile IPO, shares can fluctuate wildly once they start trading. Getting in on the secondary market entails much more risk on the day of the IPO and it is advised that smaller investors consider waiting out the first day of the IPO before jumping in.

By InvestorGuide Staff

Copyrighted 2020. Content published with author's permission.

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