IPOs are one of the most thrilling and promising financial phenomena available on the stock exchange. Sometimes called initial public offerings – IPOs for short – or just stock issues, they often produce once in a lifetime opportunities for big profits for the little guy sitting on his couch at home who buys a stake in the stock of a new company fresh off the press.
So after all this hype, what in the world is a stock issue or an IPO? And how have they made many investors filthy rich literally overnight?! More importantly, can simple mortals like you and me get in on a new stock issue? All of these questions, and anything else that may have puzzled you about this topic will be covered in this guide, helping you understand the mysterious and frequently misunderstood world of IPOs after which so many of us have lusted.
The term “initial public offering” took root in the lexicon of each and every one of us during the dot-com bubble’s bull rally in the 90’s. Back then, it seemed like a day couldn’t pass without another story of rags to riches, a dream come true for the tens of unseasoned Silicon Valley millionaires – called millionerds by others green with envy – after they hit the jackpot when their companies went public. This phenomenon implanted in our collective memory the term “siliconaires,” young dot-com entrepreneurs, in their twenties and early thirties, who, on one cloudless day became set for life. Their newfound riches enabled them to live the highlife, all thanks to the money raised by their company’s internet IPO.
+ IPOs – The Engine of Capitalism
Going public is in essence a process in which a company sells its stock to the public – and in doing so, goes from a private to a public company. In other words, the owners of a company are the body of people who have bought the company’s stock on the market. Why would a company agree to give up some of its control to shareholders like you and me?
Let’s assume that a particular company is interested in building a new factory to expand its production capacities. For that, the company needs $50 million. If it is nowhere to be found, which it very well may be, the company has 2 main options: 1) Take a bank loan 2) Raise capital on the open market, i.e. sell shares or a stake in the equity of the company – to the public. A lot of companies choose the second option for a few very significant reasons. From here on in, we’ll refer to these companies as “issuers” because they issue shares.
First, in contrast to the case with a bank loan, when a company issues shares, it’s got no obligation to return the capital it received in exchange for the shares. Investors can’t have their cake and eat it too! They either take the conservative route and keep their cash safe and sound in their pockets, or they buy a stake in the issuing company, with all the benefits they hope to reap.
Second, the issuer doesn’t have to pay back high interest rates, like it would with the bank.
Third, the funds raised from the IPO are as liquid as they come – we’re talking about piles and piles of cash. The issuer can use the capital immediately!
Lastly, the shares issued, like any other security or financial instrument, can now be traded, and any one at the issuing company can now sell his or her shares in the company (after a lock-up period) on the open market.
In effect, issuing shares has represented the locomotive of capitalism and the main engine of the stock market’s growth. Over the course of history it has been IPOs that have enabled the investing public to benefit from the prosperity so many companies have enjoyed. In this guide, we’ll teach you how you could very well use IPOs to elevate your own standard of living.
+ How a Public Company is Formed
The issuing process is not instantaneous. For a private company to be able to sell its stocks to the public, it needs to meet all of the regulatory guidelines of the Securities and Exchange Commission (SEC) to get the green light and go public. Only after this is accomplished can a private company contact underwriters and deep-pocketed private investors to try convince them to buy its stock. It’s important to remember that at the initial stage (also called “the primary market”), the company that will be going public sells all of the stock it decided to issue to brokers who divvy the shares out to their large clients who pay the initial price negotiated between the company, brokers, and IPO underwriters. The public at large can buy and trade shares from the IPO only in the secondary market after private investors and brokers given privileged access to the stock issue already purchased their shares on the primary market. Almost like with the birth of a child, the IPO is a new entity coming into being, the anticipation growing and growing until the moment the IPO for the first time sees the light of day.
+ Get to Know the IPO’s Ringleaders: The Underwriters
Like you may have imagined, the process the company needs to undergo to issue its shares to the public and raise capital, takes precious time – with many regulatory hurdles. One very important element in upgrading the status of a company from private to public is the opening of the company’s ledger for public scrutiny, as well as that of the SEC.
Being among the lucky few who get a piece of a hot IPO can range from the very difficult to the near impossible. To understand why, it’s important, first off, to understand how an IPO sets out. How does a company clear the way for selling its shares publically? This process is known as underwriting.
When a company sets its sight on going public, the first thing that it does is hire the services of an investment bank. A company could theoretically sell its stock itself, i.e. without an underwriter, but because it doesn’t have knowledge and expertise in all of the matters regarding the issuing process, its issue would presumably fail. If the company has any wits about it, it will take on an investment bank that will manage the offering; that’s simply how Wall Street works!
Underwriting refers to the process of raising funds either through issuing debt or shares. Simply put, think about underwriters as the agents serving as the liaison between the issuer and the investing public. The big underwriters on Wall Street are no other than Goldman Sachs, J.P. Morgan, Credit Suisse, and Morgan Stanley.
The issuer and the investment bank, before anything else, will meet to negotiate the terms of the deal. The topics that will typically be addressed in the initial meeting will be the amount of money the company wants to raise, the type of security to be issued and all of the details inherent in the underwriting agreement. The deal between issuer and underwriter can be closed in different ways. Take for example the “firm commitment contract.” This is in effect an agreement between the company and the underwriter in whose context the underwriter shoulders all of the risk in the issue by committing to buy all of the shares directly from the company with the aim of selling them later at a set price to the public.
On the other hand, the issuer and the bank might sign a “best efforts contract.” In this type of agreement, the underwriter sells all of the shares for the company but does not commit that it will raise a given sum on its behalf. Very frequently investment banks will hesitate to bear the full brunt of the issue’s risk. Instead, they will create a syndicate of underwriters. The head underwriter will be referred to as the lead underwriter or “book runner” or sell side firm and the others will simply be called “co-managers,” and their job will be to sell a preassigned part of the offering.
The moment that all of the sides agree on the terms of the agreement, the investment bank compiles the underwriting documentation that it needs to submit to the SEC. The documentation includes information about the offer that will be made to the public, and information about the company including financial statements, background on management, every legal liability the company faces, the intended usage of the moneys to be raised by the IPO, and the stakeholders vested in the company. The SEC then necessitates a quiet period during which they can thoroughly become acquainted with and examine the company to assure that all necessary financial information has been provided. The moment the SEC approves the stock offer, the date for “going public” is set.
Over the course of the “quiet period” the underwriters put together what is known as a “Red Herring.” This is the preliminary prospectus that includes all of the information about the issuer besides the issue price and date, which are still not known at this stage. With the information booklet in hand, the underwriter – hand in hand with the company – try to create interest, buzz and excitement for the stock issue. In tandem, the company and underwriters set out to pump up the issue to big investors using presentations, exhibitions and the like. The name that has been given to this process is the “road show.”
As the issue date nears, the issuer and underwriter sit down to decide on the IPO price. This is not an easy decision in any respect. It depends on many factors, like the identity of the company going public, the road show’s success, and most importantly, the fever on the market. If the stock market is on the upswing and stock prices are on the rise, it’s easier to nudge stock’s price higher. When push comes to shove, in the end, the issuer’s stock will be sold on the open market, with the money going from investors to the company’s purse.