IPO Process Explained

One of the most important stock market events is an initial public offering (IPO). It marks a company’s transition, from being a privately owned one, to a public listed one. It is a major step in the growth of any business and it’s important that this process is understood by beginners in stock investing.

What is an IPO?

The name ‘Initial Public Offering’ itself is quite self-explanatory about what it’s exactly all about. It is the selling of privately owned company stock, to general public, at a stock exchange. It is the process, that a company undergoes, to ‘go public’, by divestment of its private equity holding. There are many reasons why a company would want to go public. One prime reason is to raise cash, to finance its future growth. Another reason might be to pay off outstanding debts, that have been drilling a hole in its profits.

Company owners sell only a portion of their ownership in the company, in the form of shares, while retaining a controlling stake (greater than 50%) in it. An IPO also provides a company with a lot of publicity and advertising opportunity.

After shares are sold, the company, that has undergone the process, becomes public listed and its stock is available for trading, at a chosen stock exchange, which makes up the secondary market. It gets associated with any one of the indices, that are implemented at stock exchanges.

One downside of going public is that the company now has its hands tied by government regulations, that have been created to protect investor interest. Some major decisions cannot be taken without shareholder approval. The company must take its shareholders into consideration, while making any decision. So, the capital raised through an IPO does come at the expense of losing absolute control over company affairs. The company must periodically declare its quarterly profits to the shareholders, after careful audit by a third-party agency.

After the process is over, the company pockets the money, earned through selling. It doesn’t profit through secondary selling of its stocks, after the process is over. However, the way a company stock performs in a stock market, influences its image.

There are regulatory bodies, in every country, that monitor and control the whole process. The process differs from country to country. Although same in principle, an IPO in India is different from the one in USA or any of the European countries.

Process Steps

Let us now look at how an initial public offering process is initiated and reaches its conclusion. The entire process is regulated by the ‘Securities and Exchange Commission (SEC)’, to prevent the possibility of a fraud and safeguard investor interest. Here are the steps of an IPO in USA, that ultimately leads to public listing of a company, on a stock exchange and fills its coffers with surplus cash.

Selection of the Investment Bank

The first thing that company management must do, when they have taken a unanimous decision to go public, is to find an investment bank or a conglomerate of investment banks that will act as underwriters, on behalf of the company. The underwriters buy the shares of the company and resell them to the general public. The company must also hire lawyers, that can guide them through the legal maze, that an IPO setup can be. It must be ready, with detailed financial records, for intensive fiscal health scrutiny. Some companies may also opt to directly sell their shares through the stock market, but most prefer going through the underwriters.

Preparation of Registration Statement

To begin the process, the company involved, must submit a registration statement to the SEC, which includes a detailed report of its fiscal health and business plans. SEC scrutinizes this report and does its own background check of the company. It must also see that the registration statement fulfills all the mandatory requirements and satisfies all rules and regulations.

Getting the Prospectus Ready

While awaiting the SEC approval, the company, with assistance from the underwriters, must create a preliminary ‘red herring’ prospectus. It includes detailed financial records, future plans, and the specification of expected share price range. This prospectus is meant for prospective investors, who would be interested in buying the stock. It has a legal warning about the IPO, pending SEC approval.

The Roadshow

Once the prospectus is ready, underwriters and company officials go on countrywide ‘roadshows’, visiting the major trade hubs and promote the company’s IPO among select few private buyers. They are fed with detailed information regarding company’s future plans and growth potential. They get a feel of investor response through these tours and try to woo big investors.

SEC Go-ahead

Once SEC is satisfied with the registration statement, it declares the statement to be effective, giving a go-ahead for the IPO to happen and a date to be fixed for the same. Sometimes, it asks for amendments to be made before giving its approval. The company needs to select a stock exchange, where it intends to sell its shares and get listed.

Deciding On Price and Share Number

After the SEC approval, the company, with assistance from the underwriters, decides on the final price of the shares and also decide the number of shares to be sold. A day before the IPO is made in the stock market, stocks are bought by underwriters and some big investors. Money is delivered with the company, after the sale of shares.

The company does not profit from resale of shares made later. From the next day, big investors and underwriters sell company stock in the secondary market, constituted by the stock exchange. This concludes the process. The company gets money for its future plans and investment banks make money through underwriting service and resale of shares.

Stocks that are made available on the stock market, are all sold through such initial public offerings before they become available for sale in the secondary market. Smart investors study a company’s potential and buy stocks from IPOs, as they can be bought at a relative low, ‘undervalued’ price then. Profits can be made by selling these stocks later, when they reach their appreciated ‘true value’. That’s why, studying IPOs is an important part of stock investing.

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