IPO'S Initial Public Offers

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I. What is an IPO?


An Initial Public Offering (IPO) is basically a company’s first sale of equity to the public, generally in the form of shares of common stock, through an investment-banking firm. The stocks are sold in the primary market at a determined price and then are subsequently sold in the secondary market. This process transforms the company from a private to a public firm. IPO involves the stock from a young and oftentimes little-known company. But occasionally well-known and well-established firms do go public.


Most of the companies go to the Stock Exchange to finance their expansion of manufacturing or service capacity or marketing activities that have an immediate impact on earnings. On the other hand, star-up companies also use IPOs as a layer of working capital.


IPOs help to create a public market for the company’s shares, providing desired liquidity to existing owners as well as supplying necessary funding.


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II. Why do companies issue an IPO? ADVANTAGES


Companies issue an IPO to go public and to raise new capital. Some other reasons are


• Achieve liquidity and diversification for current shareholders


• Enhance the firm’s image


• Increase company’s financial base (equity financial flexibility)


• Retain and attract key work force through “Stock Option Plans”


• Expand operating capacity


• Create a negotiable instrument


• Take advantage for new business opportunities


• Make further acquisitions


Besides the above-mentioned reasons companies prefer to go public because they can raise capital at a lower price through an easier way than the private firms.


The correct execution of an IPO results on an injection of capital that will support the growth of the company in the long term, but failure in the execution of an IPO could yield the company into bankruptcy.





III. Why companies don’t want to issue an IPO? DISADVANTAGES


Companies choose to stay private because they don’t want to share their profits. Other important reasons are


• Companies don’t want to be accountable to public shareholders


• High expenses involved in an IPO


• Time involved in the preparation of reports to the Regulator


• To maintain the control of the company (avoid dilution of ownership)


• Avoid to disclose “secret” information


• Pressure to pay dividends


• Market pressure to perform short-term


Given the volatility of stock markets and the length of time required to issue an IPO, companies have to be prepared in order to issue an IPO. It will depends on the company’s strategy, financing requirements, expected growth, the companies willingness to comply with the Regulators requirements.


IV. UNDERSTANDING THE IPO PROCESS


The first step for the company is to hire an investment bank. The investment bank, also known as the Underwriter, will act as the advisor and the distributor. Underwriting is the actual process of raising capital through debt or equity. After hiring the investment bank, the company has to discuss, negotiate and agree with them, the amount of capital needed, the type of security to be issued, the price of the security, any special features of the security, and the cost to the firm to issue the securities. If they can agree on these things, the investment bank will act as the middleman between the company and the general public.


There are two different types of agreements between the investment bank and the company


1. The Firm Commitment the investment bank agrees to purchase the entire issue from the company and then re-offer them to the general public. With this type of agreement, the investment bank has guaranteed to provide a certain amount of money to the company. The risk of the issue falls entirely upon the investment bank. If it fails to re-sell the amounts of securities it purchased, the investment bank still has to pay the agreed upon sum of money to the company.


. Best Efforts Agreement the investment bank agrees to sell the securities for the company but does not guarantee the amount of capital raised by the issue.


. All or None Agreement the investment bank agrees to do its best to sell the entire issue under a certain date. All of the proceeds go to an escrow account, if the securities are not sold all at the certain date, the money is returned to the purchasers and the issue is cancelled.


The next step is to comply with the Act of Full Disclosure. This is the Securities Act of 1. The investment bank will file the registration statement with the SEC. This registration statement must contain a description of the business raising the money, biographical material on the officers and directors of the company, the amount of shares each insider (officers, directors, and shareholders owning more than 10% of the securities) owns, complete financial statements including existing debt and equity securities and how they are capitalized, where the proceeds of the offering are going (use of funds), and any legal proceedings involving the company including strikes, lawsuits, antitrust actions, copyright/patent infringement suits, all for the present time period or if they are aware of impending or future actions.


After the investment bank on behalf of the issuing company files the registration statement, the SEC requires a Cooling Off Period. During the Cooling Off Period, the issue is considered as “In Registration”. During the Cooling Off Period, the SEC will investigate and make sure that full disclosure has been made. Nevertheless, assuming the issue is approved by the SEC, the stock will be offered to the general public. This date is the “Effective Date”. If the SEC does not approve the issue, a Letter of Deficiency is issued. The letter of deficiency will notify the company what was wrong. Thus, the effective date will be postponed.


During the cooling off period the investment bank will try to drum up interest in the issue. They do this by distributing a “Preliminary Prospectus”, also known as a Red Herring because of its red printing across the top and in the margins. The investment bank pays for the printing of the red herring. The red herring acquaints the general public with the company, it contains the information from the registration statement including a description of the company, a description of the securities to be issued, the companys financial statements, the companys current activities, the regulatory bodies overseeing the company (if any), the nature of the companys competition, who the management of the company is, and the use of funds from the issue. The public offering price and the effective date are not contained in the red herring. These two things are not known during the cooling off period. Generally, the public offering price is determined on the effective date. That way, the issue can be prices in accordance with current market conditions.


During the cooling off period the investment bank may not provide any other information to its clients other than what is contained in the red herring. They cant provide research reports, recommendations, sales literature, or anything from any other firm about the company. They can only provide the client with the red herring.


If the investment banks client is interested in the issue, the client (general public) will give his stockbroker (working for the investment bank) an Indication of Interest. The stockbroker cant take an order for the issue from the client. All the client is allowed to do is indicate that he is interested. The higher the indication of interest is from clients, the better for the offering. In fact, it will probably aid the investment bank in making pricing decisions.


Before the effective date the investment bank have a Due Diligence meeting with the company. They will iron out any last minute things, which have come up. And they will make sure that there are no material changes, which have taken place between the registration date and the effective date. Due Diligence is an ongoing process for the underwriter.


Once the effective date arrives, the security can be sold and money collected. Also, the Final Prospectus is issued. This will be very similar to the red herring. Except it will have the missing numbers for the public offering price and the effective date filled in. It also wont have any red writing on it.


Then an Underwriting Agreement (UA), a contract which establishes the relationship between the corporate issuer of the securities and the underwriter is signed. After that, the Dealer Agreement is signed too. The dealer agreement or selling agreement is the contract in which securities dealers, are contracted to purchase some of the securities from the issue.. The Dealer Agreement or selling agreement will allow these dealers to purchase the securities at a discount from the offering price in order to fill order they may have gotten after the effective date from their clients.


The underwriters and dealers get paid out of the proceeds of the issue offering. The public offering price is what the general public pays. This is the amount on the face of the prospectus. However, the issuing company receives a lower price than that from the managing underwriter this difference is called the Spread. The amount of the spread is determined through a negotiation between the managing underwriter and the corporate issuer. The managing underwriter also receives a fixed amount for each share, which is sold. This is referred to as the manager’s fee.


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