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Understanding Initial Public Offerings
Investing in the financial markets is challenging and exciting at the same time. With several investment options available for investors, deciding the best asset class to invest in can be challenging. That is why having proper knowledge and awareness of each asset class in the financial markets is crucial to succeed. With several asset classes like stocks, commodities, mutual funds, ETFs, and more, one can easily get confused and overwhelmed. However, in order to understand how a company gets listed on a stock exchange, it is crucial to understand what initial public offerings are. An initial public offering or commonly known as an IPO is a process in which a private company goes public and issues its shares to the general public.
There are several reasons why a company may go public. The entire process of an IPO consists of several stages and factors that affect the IPO and determine its future and performance. You may be wondering why a private company may want to transition into a publicly-traded company? Well, in this article, we shall answer every question that you might have regarding IPOs. We will explore what initial public offerings are, how they work, why do companies go public, the advantages and disadvantages of IPOs, and several other topics. So, if you would like to learn how a private company gets listed on a stock exchange and becomes a publicly-traded company, we’ve got you covered!
What is an IPO
An initial public offering or IPO is a process in which a privately held company becomes a publicly traded company and offers its shares to the public for the first time. An IPO offers new stock issuance to the public in order to raise capital from public investors. The entire process of going from a privately held company to becoming a publicly traded company has several steps and criteria’s that companies have to follow. However, the transition from a private company to becoming a public company is an important time for the company and its investors as this is the time when they get to fully realize gains from their investments. IPOs allow the general public to invest and purchase shares of a company that will be listed on a stock exchange and becomes a publically traded company.
In order to have an initial public offering, private companies that wish to become publicly traded companies must meet requirements set by exchanges and the Securities and Exchange Commission, commonly known as the SEC, in order to hold an initial public offering. IPOs provide companies the opportunity to amass capital by offering their shares to the public via the primary market. After the IPO is complete, these shares then start trading in the secondary market, which is, the stock market. In order to conduct an initial public offering, companies hire investment banks to manage, market, gauge demand, set the IPO price band, IPO date, and much more. An IPO can also be considered as an exit strategy for the company’s initial investors and founders, allowing them to fully profit from their investment in the company.
Why Does a Company Go Public?
There are several reasons why a company may want to go public. While some companies may go public to gather more capital for growth and development, others may want to go public to offer an exit to early investors, venture capitalists, and angel investors who have invested in the company at an early stage. Let’s go over some of the reasons a company goes public –
Raise Capital for Expansion and Growth
A private company may decide to go public to generate additional capital to fuel growth and expansion. Going public is a great way to raise capital without taking on additional debt.
Exit for Early Investors
Another reason why a company may go public is to allow an exit to early investors. These investors can be venture capitalists, angel investors, and other founders of the company who invested at an early stage and want to capitalize on their investment.
Success and Credibility
A private company may also decide to become public in order to highlight its success and show its credibility to the world. This allows the company going public to display its brand to the world and allow people to be a part of their success.
How Does an Initial Public Offering Work?
The entire transition of going from a private company to a public company and having an initial public offering is a time-consuming and challenging process. Organizing an IPO is a lengthy and document-intensive process and that is why companies hire an underwriter, usually an investment bank, which helps them navigate the entire process of the IPO from the start to finally getting listed on the stock exchange. Becoming a publicly traded company means a private company must prepare itself for an exponential increase in every aspect of its business and also get ready for the lengthy paperwork and processes in order to meet the SECs requirements.
Organizing an IPO requires a private company to prepare a lot of documentation and financial disclosures to meet all the requirements laid out by the SEC. That is why any private company which plans to go public hires an underwriter. These underwriters or investment banks could be one entity or multiple investment banks working together for the company. They help the company prepare for the IPO and create key documents, schedule meetings with potential investors, decide the price and date of the IPO, organize roadshows, manage issuance, and help with the overall process of an IPO. Once the company and its advisors finalize an initial price for the IPO, the underwriters proceed with issuing shares to investors. This is the beginning of the journey for any company which is going to get listed on a stock exchange and become a publicly-traded company.
The Entire Process of an IPO in a Nutshell –
- A private company decides to become public in order to raise capital from public investors or provide early investors an exit.
- The company hires an underwriter or multiple underwriters to manage every aspect of the IPO that includes research and due diligence, documentation, paperwork, filing, marketing, deciding pricing, and finally issuing the shares.
- IPO teams are created with underwriters that include lawyers, certified public accountants, and Securities and Exchange Commission experts.
- Documentation is finalized and a board of directors is formed.
- Approval from the Securities and Exchange Commission is granted.
- The company finally issues its shares on an IPO date with a fixed price or a price band.
- Company shares finally get listed on a stock exchange on the listing date and the private company becomes a publicly traded company.
Types of Initial Public Offerings
There are two common types of IPOs that a private company can opt for. The first is a “Fixed Price Offering’, and the second is a “Book Building Offering”. Both types of IPOs have different ways of finalizing a price for the IPO. Let’s understand them in detail –
Fixed Price Offering
In a fixed price offering, the company determines a fixed price at which they plan on issuing their shares to the public investors. This process allows a private company that plans on going public to pre-determine the price at which they will issue their shares. In order to participate in a fixed price IPO, investors have to pay the full share price in order to successfully file an IPO application.
Book Building Offering
In a book building offering, the company offers a 20% price band on shares being issued to the public. Investors can place their bids within the given price band. The lower level of the price band is known as the floor price and the upper limit is known as the price cap. This gives the company going public the ability to get the best price for their shares using investor demand as a price-determining agent. The final share price is then determined using investor bids.
Advantages of an Initial Public Offering
The main objective of an IPO is to raise capital for the company going public. However, an IPO also offers several other advantages like –
- Access to a larger investor base and a huge inflow of funds from several different sources.
- Going public helps a company increase its transparency. By publish quarterly reports and showing their performance publically, they can build a strong company image which can help in credit borrowing.
- Becoming a publicly-traded company also allows a company to raise additional capital in the future via secondary offerings.
- An initial public offering and going public can help companies gain exposure, prestige, build a better public image which in turn can help in sales and profit.
- Public companies can attract better management and skilled professionals via methods such as ESOPs.
Disadvantages of an Initial Public Offering
While going public and opting for an IPO has several advantages, this process can oftentimes have several disadvantages for companies. Some of those disadvantages are –
- An Initial public offering is an expensive process that takes up a lot of time and resources. Additionally, the costs of maintaining a public company are quite high when compared to doing business as a private company.
- Becoming a public company means any organization is obligated to disclose their finances, accounting, taxes, and other business information to the public.
- Going public increases the financial pressure on a company as there are significant legal, accounting, and marketing costs associated with being a public company.
- There is always a risk of not being able to gather the required amount of funds via the IPO if the public forms a negative sentiment about the company.
History of IPOs
The earliest case in history where a company issued public shares was in the case of the “Publican” during the Roman Republic. However, the first modern IPO was held in March 1602 by the “Dutch East India Company”. They offered shares to the general public in order to raise capital. The Dutch East India Company (VOC) became the first company in history to issue bonds and shares of a stock to the general public. VOC was the first publically traded company in history as its shares were the first to be listed on a stock exchange and be bought or sold by investors. Since then, IPOs have been a great way for companies to generate capital via the issuance of shares to the general public.
We hope that this article provided you clarity on the topic of initial public offerings. While IPOs are a great way for investors to invest in a company in its early stages of growth, one should carefully analyze and decide whether or not the investment is worth the risk. Oftentimes, IPOs prove out to be a great way of generating wealth in the short term, however, they can also underperform leading to huge losses and capital depreciation. So, we suggest that you always carefully consider and analyze a company and its future outlook before investing in its IPO. We hope that this article provided you with valuable information and knowledge. If you would like to learn more about the stock market and finance, then do check out Jeremy’s YouTube Channel “Financial Education”. Happy Investing!