An Introduction to IPOs: What Is An IPO?
An Initial Public Offering or IPO is a process where a business offers shares to the public. A group that starts as a private entity will go public by offering stock to people for the first time.
An IPO means that a business is going from private ownership to public. The effort allows investors to buy stock in the company.
People can buy stock to hold partial ownership in a group. Those investors can receive dividends in some situations. But the main goal an investor has is for the stock price to continue rising, allowing that person to sell off the share at a profit.
IPOs are often signs that a business is strong and is consistently growing to where it’s finding a new way to raise funds. But the IPO can also be risky, as a stock could be overvalued or undervalued in some situations.
Why Do Companies Go Public?
The main reason a private business would start the IPO process to go public is to raise funds. A group could pay off some debts or fund future operations. Selling part of their business in the form of shares can help a business raise the funds it requires for many functions.
Some businesses may also go public because they want to bolster their public profiles. Offering shares can allow a group to become more noticeable.
How Does An IPO Work?
An IPO works by allowing a business to produce shares at a particular value to the public. A privately-owned company will have a valuation based on its income, assets, revenues, and other factors. But with an IPO, the business will have a more definite idea of its value, as it is offering shares whose values can shift.
A business will consult an investment bank for help and find a way to price the IPO. The shares the business provides will then go on a stock exchange where the public can buy and sell those assets. This measure can make a company more interesting to the public while also offering a new way for the business to raise funds.
The IPO Process
The timeframe for when an IPO will be ready will vary by group. An IPO could take about six to nine months from the start to when the company makes its public debut.
There are five critical steps for a business to follow during the IPO process:
- Choosing An Investment Bank
First, a business must consult an investment bank that will help facilitate the IPO. The bank will analyze the offering and establish a suitable value. The bank will base this value on various aspects like revenue, assets, and general business projections.
The investment bank will use the valuation to determine a suitable share price and how many shares the business should provide. A date for the IPO can also be established through the bank’s support.
- Filing With the SEC
The next step is for a business to register its IPO with the Securities and Exchange Commission or SEC. An S-1 filing is necessary for getting the IPO ready. The S-1 report includes various points on how well the business runs and what prospects it has for further growth.
An S-1 filing will include details on these points:
- The business model
- How the business compares with others in their field
- The process that will work when setting share prices
- Info on the company’s board of directors
- The current financial situation for the business
- Details on the underwriters for the IPO
- The proceeds an IPO will raise
Everything a business lists in its S-1 filing must be accurate and complete. A business that doesn’t complete the filing will either have its IPO rejected or experience a substantial delay in how that IPO will become ready.
- Pricing the IPO
The shares for an IPO must have a price before a company goes public. There are multiple things that will go into the valuation process for an IPO:
- Current demand for shares
- Industry comparables, or how other similar properties are valued
- The potential for growth within the company
- Any appealing corporate narratives, including how cutting-edge or distinct a business is
The pricing process is often laborious, as a stock with a high value doesn’t necessarily mean the business is substantial. A good example came in the 2000s, as many dot-com companies had high-value IPOs. But while their values were high, that didn’t mean those businesses were stable or that massive. Many people were led to believe these groups were viable for investing, but they didn’t notice some of the struggles that these groups had been dealing with, making it to where their stock values would eventually decline.
The risk of overvaluing the IPO can be dangerous, as it is possible for the share value to drop after a while. A stock with a higher value during its IPO will be more likely to see a dramatic decline that can cost a business more money than it could afford.
Sometimes a price band can also go into the pricing process. A price band is a measure where a seller will provide upper and lower cost limits. Buyers can place their bids on stocks within the IPO in that range, guiding the buyers to a proper price.
But in most cases, a fixed price will work. A fixed-price IPO is where a company creates a defined price for how well the stock works. This option can work if a company expects to see its value stay the same, but any situation where a company sees dramatic growth or other changes might make that fixed price less viable than what one might expect.
- Marketing the IPO
The marketing process for the IPO is another consideration to review. The marketing effort can include highlighting the unique things available in the IPO.
Underwriters will be responsible for gathering private bids for shares. Underwriters can also prepare public statements highlighting the IPO and where it will be available alongside the first date people can acquire the shares.
Additional financial reviews can occur at this point to ensure the accuracy of the IPO. An analyst or underwriter can adjust the IPO’s price or delay the issuance date if necessary.
All marketing actions should be accurate and available to the public. The SEC can also review these marketing points to confirm their accuracy.
- Trading on the Stock Exchange
The company will then issue its shares on the designated IPO date. A company will choose an exchange based on a few factors:
- Where the company and its prospective shareholders live
- Accounting standards to follow
- How many shareholders are involved
- How much a business spends on listing and compliance costs
- The way how the stock exchange operates
NASDAQ and the New York Stock Exchange are the two most common stock exchanges for an IPO. The NYSE has a listing fee of $225,000 for IPOs, plus the NYSE operates as a trade facilitator. The facilitation process means the NYSE will match the highest buyer bid with the lowest seller bid to complete sales, a practice that can become volatile.
NASDAQ has a $75,000 average listing fee for IPOs and works as a broker-dealer market. When someone sells a share, NASDAQ will buy it even if it doesn’t have a seller to send the shares back to, so NASDAQ has to hold some shares depending on what happens.
Regardless of whatever a business chooses, NYSE and NASDAQ require a company to have at least 300 shareholders. An over-the-counter exchange can work if a business has fewer than 300 shareholders, but those exchanges are only open to high-net-worth investors, thus making the IPO less accessible. Over-the-counter sales are also unregulated, so there could be a substantial risk of investors and businesses losing money in the IPO.
The process of getting the IPO ready takes a while, but it is all about allowing a business to become more visible and inviting to possible investors. An IPO has to be detailed and accurate, plus the value should be rational to where the risks that investors and companies can incur will be minimal.
The Benefits of an IPO
Raising Capital
One point people should see when looking at what is an IPO entails how an IPO can benefit a business. One way it can work well is from how a team can raise more capital.
The investing public will send its funds to the business through the IPO, making it easier for a team to get more capital. A group will have an easier time managing various operations, plus the work can help boost a business’s public image.
The capital can help a business manage many operations, including efforts for expansion, production, and hiring people. The enhanced operations can lead to the business being more profitable or viable. There could also be cases where the company keeps growing to where it can justify having higher stock prices.
Sometimes the IPO can become popular enough to where a group can use a green shoe option. This over-allotment option is an underwriting agreement where an underwriter can sell more shares than what was initially included. This effort can work in cases where the share’s demand is higher than anticipated. This option can help for many stock purposes, but this only works when the contract to get the IPO ready allows a team to offer this feature.
Providing Liquidity
Another reason many businesses start IPOs is to increase their liquidity. An IPO gives liquidity to investors by allowing them to sell shares. Since people can exchange shares as necessary, it’s easy to make profits whenever the stock does well.
The prices of shares will change through supply and demand in most situations. The price keeps rising when the number of people who want to buy a stock overwhelms the number looking to sell. General consumer perceptions and competitive forces can also impact the liquidity of the shares.
Stock prices only change during trading hours, so there’s often a time for people to plan their trades before the market opens. The added effort people put into finding stock of value helps them see what works on the market.
Increasing Visibility
It’s often easy for people to trust a business when it appears on a stock exchange. An IPO can make a business more visible, as it can suggest that a company is active in the market and wants to keep growing.
Many IPOs are heavily promoted in the media, especially when the IPO is a more visible asset in a market that could rise. A business can consider an IPO a useful marketing tool, as it suggests a business is ready to start growing.
Since people are becoming aware of the business through its IPO, that team can grow and experience more sales or transactions. People might also want to buy shares themselves if they notice there’s a strong opportunity for the business to grow. But this effect only works when a business has a plan for operation and is ready to increase its assets.
The Risks of an IPO
Underpricing the IPO
An IPO can be an exciting time for a business, but the IPO process is also risky. One problem a business might encounter involves when it underprices the IPO.
A company might sell underpriced stocks to encourage more people to invest in it. The effort might also help increase publicity and awareness for the company.
But underpricing can also unintentionally occur, as a business might underestimate the general demand for a stock. Legal proceedings might also impact the pricing, as there could be too much uncertainty over how well the IPO will operate.
Underpricing the IPO can cause a business to lose money, plus the group might not have as much control over what it wants to do when the pricing goes down too much.
Overpricing the IPO
Another risk in an IPO entails how it might be overpriced. An IPO that is overvalued could be tougher for some investors to enter, as some might suspect that the company isn’t worth as much as the IPO suggests.
Overvaluing the IPO can also cause the stock to quickly drop in price after the IPO period ends. This drop makes it harder for a stock to become viable, plus a group could experience lots of negative publicity in the process.
Some businesses still intentionally overprice their IPOs to help cover costs that the underwriting bank might incur. That bank will only make money off of the initial issuing of stock, so having the IPO be worth more might be necessary for satisfying the interests that a company holds.
Volatility In the Stock Price
Volatility is another threat to notice in an IPO. Volatility refers to how quickly the stock price can rise or drop.
An IPO stock is more volatile in its first few trading months. There could be an inaccuracy in how a business was valued during the IPO, causing the stock price to experience substantial shifts.
The amount of trading volume for a stock can also influence the volatility. People might be heavily interested in the stock at the start, but the demand will dwindle as time progresses. This effect could create a negative impact on stock values unless the business starts growing and stays relevant well after the IPO starts.
Conclusion
An IPO is an exciting time for a business, as it’s a moment where a business can start raising funds and become more visible. But the process for getting an IPO ready is extensive, as a group has to work towards creating reports to ensure enough accurate info is available. The details have to be accurate to ensure the IPO is worth enough money and that it’s not being overvalued or undervalued.
Any business looking to create an IPO can consult the SEC for further details on the requirements necessary for establishing that IPO. Underwriting banks can also be consulted for additional help to see how the valuation process works. Businesses are encouraged to contact multiple banks to get different ideas on how their IPOs are to be valued and to determine if entering an IPO is worthwhile or if the group should wait.
Are you looking to get an IPO ready for your business? You can contact us at the Wheeler Group for further info on how an IPO can work and what you can expect. Our fractional CFO services can help you understand how IPOs operate while helping you review your determine to see if you’re ready for an IPO.