Initial Pubic Offer (I.P.O)
An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO.
Companies fall into two broad categories: Private and Public.
A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company: just put in some money, file the right legal documents and follow the reporting rules of your jurisdiction. Most small businesses are privately held.
It usually difficult to buy shares in a private company. One can go to the owners for investing, but they're not obligated to sell anyone anything. Public company, on the other hand, have sold at least a portion of itself to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public."
Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. In the India, public companies report to the Securities and Exchange Board of India (SEBI). An investor can trade the stocks of a public compnay in the open market, like any other commodity. If one has the cash, he can invest.
Why Go Public?
Going public heps raising cash. Being publicly traded also opens many financial doors:
1. Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
2. As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.
3. Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.
4. Being on a major stock exchange carries a lot of prestige. In the past, only private companies with strong fundamentals could qualify for an IPO and it wasn't easy to get listed.
The Underwriting Process
When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required. Underwriting is the process of raising money by either debt or equity. You can think of underwriters as middlemen between companies and the investing public.
The company and the investment bank will discuss the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.
Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the SEBI. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used and insider holdings. The SEBI then requires a cooling off period, in which they investigate and make sure all material information has been disclosed. Once the SEBI approves the offering, a date (the effective date) is set when the stock will be offered to the public.
During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue. They go on a road show where the big institutional investors are courted.
As the effective date approaches, the underwriter and company sit down and decide on the price. It depends on the company, the success of the road show and, most importantly, current market conditions. Of course, it's in both parties' interest to get as much as possible.
Finally, the securities are sold on the stock market and the money is collected from investors.
It's hard enough to analyze the stock of an established company. An IPO company is even trickier to analyze since there won't be a lot of historical information. The main source of data is the red herring, one must examine this document carefully. Look for the usual information, but also pay special attention to the management team and how they plan to use the funds generated from the IPO.
The Lock-Up Period
If one look at the charts following many IPOs, you'll notice that after a few months the stock takes a steep downturn. This is often because of the lock-up period.
When a company goes public, the underwriters make company officials and employees sign a lock-up agreement. Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The period can range anywhere from three to 24 months. Ninety days is the minimum period but the lock-up specified by the underwriters can last much longer. The problem is, when lockups expire all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.
Flipping is reselling a hot IPO stock in the first few days to earn a quick profit. This isn't easy to do, and you'll be strongly discouraged by your brokerage. The reason behind this is that companies want long-term investors who hold their stock, not traders.
Of course, institutional investors flip stocks all the time and make big money
. The double standard exists and there is nothing we can do about it because they have the buying power. Because of flipping, it's a good rule not to buy shares of an IPO if you don't get in on the initial offering. Many IPOs that have big gains on the first day will come back to earth as the institutions take their profits.
Avoid the Hype
It's important to understand that underwriters are salesmen. The whole underwriting process is intentionally hyped up to get as much attention as possible. Since IPOs only happen once for each company, they are often presented as "once in a lifetime" opportunities. Of course, some IPOs soar high and keep soaring. But many end up selling below their offering prices within the year. Don't buy a stock only because it's an IPO - do it because it's a good investment.
1. An initial public offering (IPO) is the first sale of stock by a company to the public.
2. Broadly speaking, companies are either private or public. Going public means a company is switching from private ownership to public ownership.
3. Going public raises cash and provides many benefits for a company.
4. The process of underwriting involves raising money from investors by issuing new securities.
5. Companies hire investment banks to underwrite an IPO.
6. The road to an IPO consists mainly of putting together the formal documents for the SEBI and selling the issue to institutional clients.
7. An IPO company is difficult to analyze because there isn't a lot of historical info.
8. Lock-up periods prevent insiders from selling their shares for a certain period of time. The end of the lockup period can put strong downward pressure on a stock.
9. Road shows and red herrings are marketing events meant to get as much attention as possible. Don't get sucked in by the hype.