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investor exit strategy: initial public offering (ipo)

Commonly referred to as “offering” or “flotation”, IPO or Initial Public Offering is a process in which a company, called the issuer, issues common stock or shares for open public buying for the very first time. An IPO is usually undertaken by smaller, emerging companies looking for a source of capital in a bid to expand its business. However, an IPO can also be issued by a large, privately managed company seeking to list its shares in public trading.

It is usually not possible to acquire shares of a private firm. However, you can proceed to invest in the company, but the company has no right to show you anything. On the other hand, public companies have sold a part of their business to the public and posses a trading right on the stock exchange. Hence, in a nutshell it can be said that an IPO is a process in which a private firm turns public.

Emerging or smaller firms issuing an IPO usually take help from an underwriting firm in a view to know the type of security that needs to be issued, the best price of the IPO and the right time to land it in the market.

IPO definitely involves a lot of risk since it is difficult to discern as how would the shares or stocks perform on its first trading day and in the near future, primarily because there is very less historical information present to discern the company performance trend. A majority of the companies issuing an IPO are those undergoing a nascent growth period. For the very same reason, they are often imposed with an additional unpredictability of their future value and overall performance.

Need for IPO

Apart from assisting the financial backup of the company, an IPO insinuates myriad positive vibes in the company.

  • Due to hiked increased scrutiny, public companies can have access to better rates when they issue debt following their IPO.
  • Till there is a robust demand in the market, a public company has the right to issue more stock. Hence, an IPO makes mergers and takeovers easily feasible as stock can be issued under the deal only.
  • Public opening of shares or stocks of a particular company triggers liquidity. Easy money flow ensures that tasks as employee stock acquisition plans are possible thereby assisting in luring top talent.
  • In addition, an IPO serves as a podium for diversifying and boosting equity base.
  • IPO facilitates cheaper and faster access to money.
  • IPO can be a method to have an exposure to the public market.
  • IPO can be advantageous as it can help in luring the best management and employees in a company and reduces their likeliness of leaving the company.
  • IPO can serve as a major source for facilitating takeovers.
  • Being a robust source of capital, an IPO give birth to numerous financing opportunities like equity, convertible debt, and cheaper bank loans, etc.
  • Lastly, an IPO can serve as a podium of liquidity for equity holder.

IPO Process

The main IPO process involves one or more investment banks, called as underwriter in business lexicon. The issuers i.e. the company seeking to publically offer its shares enters a deal or a contract with a top underwriter in a view to publically list its shares. However, the underwriter then in turn offers these shares to investors. The process is called underwriting.

The underwriting contract involves some stated items including the amount of capital a company will raise, security type to be issued along with other information. However, the contract can be framed in myriad ways. For instance, in a normal commitment, the underwriter ensures that a fixed amount of capital will be raised by acquiring the entire public offer and then reselling it to the public at a different price. In a ‘best efforts underwriting’ contract, the underwriter sells securities for the firm, but does not involve a guarantee for the capital raised. In addition, investment banks don’t indulge in bearing all the risk of an offering completely on themselves. Instead, they establish a group of underwriters and not only a single underwriter so that the risk involved get distributed. But, there is one underwriter spearheading the syndicate and the others are involved only for a portion of the issue.

Once all the underwriters facilitate a nod for the underwriting contract, the investment bank puts forwards a registration statement. The statement presented is then filed with the SEC. This document includes all the necessary details related to the public offering including financial statements, management working, and legal issues. In addition, it details the information of the company such as where the money is to be diverted and all the insider holdings of the company.

The SEC then seeks for a cooling off period. The time is utilized in validating the information posed in the document. The SEC carries an investigation to discern whether the information is correct or not. Following an approval from the SEC, a particular date is fixed in a view to set when the stock will be publically opened for buying.

The information gathered during the cooling off period is known as red herring. However, this included just an initial prospectus bearing all the details related to the company except the price of the IPO and the date for the IPO. As the red herring is formed, the underwriter and company raised to trigger the value of the shares. They create hype for the shares in a view to develop interest for the issue. Road shows are major measures resorted for the same.

With the effective date approaching, the process of fixing the price of the shares is decided on the last moment. The process of fixing the price is not very easy as the company and the underwriter needs to scrutinize various factors prior to setting the price. The factors involved are: the level of demand for the company, the hype created by the road show and the current market scenario.

The sale which involves both costing and allocation of shares usually bears myriad forms. The major methods involved are Best efforts contract, All-or-none contract, Firm commitment contract, Bought deal, Self distribution of stock, and Dutch auction.