Earlier this week, we wrote about a slew of IPOs ready to take place. One of them that I was particularly excited about, Caesar’s Entertainment Group, died just a day before it was supposed to go public so I wanted to know what the process is for a company to go public. An initial public offering (IPO) occurs when a company issues shares of stock to the public for the first time. It is a major milestone for most corporations, and marks the point at which a company first becomes publicly traded. Most companies that offer IPOs are on the smaller side. These companies are looking to gather capital to expand their business, and use the proceeds from the sale of stock to do just that. That said, there are larger private companies that hold IPOs because they seek to become publicly traded.
The first step for a company looking to issue an IPO is to select an investment bank to advise the company, and to perform underwriting functions in the offering process. Which investment bank performs these tasks historically depends on the bank’s expertise and the preferences of the issuing firm, as well as the bank’s understanding of the issuing company’s industry. Also, firms tend to select an underwriter based on whether or not the firm would prefer the bulk of its shares held by institutional (mutual funds, pensions, etc.) or individual investors. Some investment banks have more expertise when it comes to distributing offerings to institutional investors, while others are better suited to individual investors. Frequently, the selection of an underwriter can come down to relationships between investment banks and the issuing company, particularly the members of its board. Underwriters are often equally selective in choosing whether or not to underwrite a firm’s IPO.
Companies offering stock often use multiple firms to issue their stock. This is up to the issuer, and is typically used as a means of offering the IPO shares to a more diverse group of investors. In these arrangements, one firm will act as a lead underwriter, and be primarily responsible for the complex process of registration and promotion required of an IPO. The process of going public typically takes around six to nine months. It requires an audit and filing extensive paperwork, particularly the registration statement, with the SEC. The underwriter is responsible for filing this statement. After this is approved, the underwriter typically files an acceleration request to move the effective date of the issue up to a date chosen by the issuer based on market conditions.
After the close of the stock market on the day before the effective date, the issuing firm and lead underwriter decide two very important details: the number of shares sold and the price per share. These numbers are set based on the company’s books and market conditions. Close attention is paid to investor demand for the securities. The two parties closely note the orders that the underwriters have on hand for the stock. (Many investment banks say that an IPO should have two to three times as many orders as it does available stock.) Available data insists that IPOs are typically undervalued. In other words, most IPOs are priced so that investors can expect a rise in price on the first day. Many firms believe this short changes the funds they can gather, but others consider this situation preferable to having an unsuccessful offering. It was at this point that the Caesar’s IPO fell through, as the market conditions for their IPO were deemed extremely poor. (No interest)
Once the price and quantity of shares are settled, the underwriter and issuer finalize a few documents, and the offer begins with market trading the next day. The IPO transaction ends in three days. At that time, the company delivers its stock and the underwriter transfers the net proceeds from the IPO to the firm.
Immediately following the IPO, the underwriter is required to support the price of the stock by purchasing shares if the price dips below the IPO price. 40 days after the issue, an SEC required “quiet period” ends, and the underwriter begins to comment on the valuation and provide earnings estimates on the newly public company. The underwriter thus transitions from an advisor of the issuing company to an evaluator.
Because the future of any newly public company is murky, IPO investments can be very difficult for typical individual investors to navigate. Most companies issuing an IPO have very little public history for investors to evaluate. If the company tanks, you can lose big. But, consider for a second how wealthy you would be if you had invested in the IPO of any of Wal-Mart, Target, or Starbucks. For a more recent example, consider Google. The internet giant went public in August of 2004 at a share price of $85. As of this writing, Google’s stock closed at a share price of around $590.
If you’re interested in investing in an IPO, first consider how risk averse you are. Can you afford to place this sum of money in a risky venture? Second, take a good hard look at your emotional temperament as an investor. The early days of a newly public company can be hugely volatile. The price of a stock can fluctuate wildly. Ask yourself whether or not your emotions will make it difficult for you to hold onto shares if they drop 30, 40, or 50 percent, but you still believe the long-term outlook to be good.
If you’re ready to invest in such a risky strategy, you’ll have to a close, qualitative look at the business. IPOs cannot offer the wide array of data available to investors considering publicly traded companies. You won’t be able to observe historical high and low prices, price to earnings ratios, or historical earnings. What you can look at is they company’s business model, it’s plans for expansion, and other factors that give it a key advantage over other companies. If the company has key executives or holds key patents or trademarks, these things might help shield them from volatile market conditions. Lastly, consider the likelihood that this company fails outright. Say they’re offering an innovative new product. Is there a way to ascertain demand for this product? How competitive will it be with similar products already in the market? Evaluating IPOs is unlike evaluating any other investment. If you’re serious about it, do some extensive research reading on methods of evaluating IPO investment.
Although many investors try to make quick money in IPOs, the truth is that it’s a very risky endeavor. Many experts suggest that the soundest way to invest in IPOs is to make them a small portion of your overall portfolio (this helps mitigate the pretty substantial risk), and to limit your selections to companies whose products you genuinely believe have long-term market prospects. If you can’t handle the emotional swings, investing in IPOs may not be for you. But, if you can put aside the volatile swings and make cold, hard decisions about a new company’s prospects, you can possibly reap vast rewards from a shrewd investment in an IPO buy using an online discount broker, where your trading costs are minimal.
Published or updated November 23, 2010.