IPO

What is an IPO: how the company goes public

Going public makes the company known, gives status, and most importantly, opens access to capital. How does an initial public offering happen and should investors invest in an IPO?

Contents of the article:

1 — What is an IPO
2 — Stages of a company going public
3 — How to participate in an IPO
4 — Is it worth buying shares in the first days of the IPO

What is an IPO

Every company is looking to raise capital to grow their business. At the initial stage – the startup stage – it is difficult for it to attract a bank loan or find an "angel" willing to invest in its development. And then the company issues shares that are offered to investors. Anyone who buys a share in a startup becomes a co-owner.

If the business is successful, it needs additional capital to grow further. Of course, you can take a loan or issue bonds, promissory notes. However, the most profitable option is to issue shares to be traded on the stock exchange. This has the potential to attract millions of investors and billions of dollars of investment.

An Initial Public Offering, or IPO, is the first public sale of a company's stock to the public. During an IPO, a company issues shares and lists them on the stock exchange, and any willing investor or investment fund can purchase the securities.

This is a costly process, but if the offering is successful, the company will be able to raise hundreds of thousands, millions, or even billions of dollars.

IPO stages

A company can't just issue new shares and immediately place them on the stock exchange. Before that, it will have to go through several stages involving investment banks, lawyers, marketers and many other experts. The company must prepare itself for the fact that it will no longer be private but public, as this market has its own rules and requirements.

To go public, a company must have a good business history and prepare transparent accounts and records for several years. For example, only a company with a preliminary value of at least $50 million can list its shares on the New York Stock Exchange.

Once a company has thought about an initial public offering on the stock exchange, the pre-IPO phase begins.

Preliminary stage The preliminary stage is the longest, and can last from a few months to several years. During this time, the company should evaluate its business, asset structure and corporate governance. Then you can calculate at what price and how many shares should be issued and therefore determine the future capitalization of the company.

It is also important to assess the degree of financial and information transparency. This builds investor confidence in the company and enhances its reputation. In addition, the future issuer, according to the rules of exchange trading, is obliged to publicly provide quarterly financial statements.

Based on the results of the analysis, the company decides whether it is profitable for it to take its shares to public sale. The Board of Directors, after weighing the pros and cons, must make a judgment whether to go public or not. If so, the company signs a contract with the underwriter and the next, preparatory stage of the IPO begins.

Preparatory stage
An underwriter – usually an investment bank with which the company enters into an agreement – is in charge of all the preparatory work of listing shares on the stock exchange. Usually there are multiple underwriters working on an IPO. In addition, the stock exchange where the shares will be listed and brokers are selected.

The underwriter evaluates the company and, taking into account market conditions, determines the parameters of the upcoming IPO: how many shares will be issued and at what initial price, as well as when is the best time to issue the securities to the stock exchange.

The company, together with the underwriter, then prepares a prospectus for the regulator of the country where the IPO will take place. In Russia, it is the Bank of Russia that controls the stock exchanges operation, while in the United States it is the Securities and Exchange Commission (SEC).

The prospectus contains detailed information about the company: data on management and shareholders, financial statements, dividend policy. The company should also explain why it has decided to raise funds, how many shares it plans to issue, the timing of the offering and more. If the information provided in the document meets all the requirements of the regulator, an IPO date is set.

In addition to the prospectus, the underwriter and the issuer prepare an investment memorandum – a document that contains the data necessary for investors to decide whether or not to invest in the company.

Finally, an advertising campaign is launched – to increase investor interest in the securities being offered. Company representatives meet with potential investors and brokers while traveling to major global financial centers such as London, New York, Hong Kong or Tokyo. In such a "road show," management discloses the company's performance and offering data to investors. The Road Show usually lasts two to three weeks.

"Firm commitment"
In this case, the underwriter assumes a great risk, as he fully guarantees the sale of the issuer's securities. He himself buys all the shares that are offered for IPO and then resells them on the stock exchange. But he himself may take a loss if he can't sell them for more than he bought them from the company. Usually this underwriting is done with high quality companies or those that investors are interested in.

"Best efforts".
The underwriter undertakes to make every effort to sell the shares, but must not buy them. In this case, the issuer risks more. These transactions are conducted by firms that specialize in the more speculative securities of new and "immature" companies.

"Standby Commitment or Standby underwriting".
The underwriter agrees to buy shares that remain after the IPO and have not been purchased by other investors. In doing so, it buys securities at the subscription price, which is usually below the market price.

Main stage
During the Road Show, preliminary bids for the issuer's shares are collected. Large investors get the right to buy shares before they are officially offered. Based on the bids collected, the underwriter receives information about how many shares investors are willing to buy and at what price. By the way, the underwriter has a pre-emptive right to buy shares before the IPO with their further resale after the offering.

If a company's IPO causes a stir, demand for shares may exceed supply – this is called oversubscribing the order book. Then the company and the underwriter decide what to do. They can increase the stock price or issue additional securities

Final stage
The final stage, or listing, is the beginning of the circulation of securities on the stock exchange. With the start of trading on the stock exchange, the effectiveness of the IPO will finally be seen. If the price of securities is adequate to market conditions, the issuer can count on forming a stable reputation on the stock market and on increasing its capitalization.

How to participate in an IPO

To participate in an IPO, you need a brokerage account. You must have a certain amount of money in your account that you want to invest in stocks. In addition, there is a minimum amount you need to have to participate – this varies from offering to offering, and can be in either US dollars or Euros. It depends on the company and the price of its securities.

If you already have a brokerage account, you should:

Choose a company;
Research information about the upcoming offering, dates for accepting bids;
Find out who can participate in the IPO.

Top up your brokerage account with the required amount;
Bid in the app, on the website or at the broker's office;
In case of over-subscription, the broker may reject the bid or may not execute it completely. Then you'll need more money and a new bid if you meet the deadline to submit it;
You will be notified once the bid has been fulfilled.

There is such a thing as allocation – it's how many percent of the number of bids will be fulfilled. The broker along with the underwriter distribute the securities from the largest investors to the smallest investors. And, of course, investors with large capital are a priority.

So there is a chance that your bid will not be executed or will not be fully executed. For example, you wanted to buy 100 shares of a company, and 50 were credited to your account. Money will be charged from you only for those shares that you got.

Is it worth buying shares in the first days of the IPO

"RBC Investments" investigated IPOs conducted in 2020. According to the data received, the average price increase on the first day of trading relative to the offering price was 49.7%. The larger the offering, the smaller the loss an investor could suffer, the study found. The average increase on the first day of trading for the top ten IPOs of 2020 is 54.9%.

As for smaller IPOs, there can be a significant increase in share price, but also a greater chance of a loss. A cautious investor is better off looking out for the largest offerings.

According to NASDAQ data, stocks rose an average of 34% on the first day of trading in 2021. However, the value of median, typical stocks only increased 13% compared to 26% in 2020. In addition, the shares closed down – below the offering price – on the first day of trading in 33.6% of cases.

Remember that there are always risks, and no one can guarantee that you will make money on an IPO. Think carefully about your decision. Don't forget to study the prospectus and investment memorandum to learn more about the company and its business.