Initial Public Offering (IPO)

How Does an Initial Public Offering (IPO) Work?

The term IPO stands for “Initial Public Offering” and describes the process in which a private company issues shares of itself to the public.

The securities issued, most often common shares, represent partial ownership stakes in the underlying equity of the issuer.

An initial public offering (IPO) is a major milestone for many private companies, as most venture or growth-capital-backed companies strive to someday become publicly traded.

Once the formerly private-held company has undergone an initial public offering (IPO), it is now recognized as a public company, i.e. it has “gone public”.

An IPO is an opportunity for a private company to raise significant capital by offering its shares to the public, while existing investors can exit their holdings and realize a return on their investment once the lock-up period has passed.

The newly issued shares of the company are then listed on a stock market exchange, such as the New York Stock Exchange (NYSE) or the Nasdaq.

Stock exchanges like the NYSE and Nasdaq function as a centralized market connecting buyers with sellers, with the market participants ranging from retail investors to institutional investors such as hedge funds.

^{Investing in an IPO (Source: SEC Investor Bulletin)}

What is the IPO Process Timeline?

• Step 1. Hire Underwriters → Traditionally, the IPO process is initiated by a private company hiring several investment banks—often referred to as “underwriters”—to advise on the transaction and ensure the maximum amount of capital is raised, with the minimal amount of issues encountered (e.g. conflicts with regulatory requirements).
• Step 2. Red Herring Prospectus + Roadshows → Once the company prepares to “go public”, the investment banking advisors will market the company to institutional investors via “roadshows” to first secure demand from those investors with substantial sums of capital. The roadshow comprises a series of presentations given by senior management alongside their team of advisors to potential institutional investors to gauge their initial interest and figure out how to convince them to participate, i.e. “book building”. Before the roadshow, the advisors also prepare a preliminary prospectus, also known as the “red herring prospectus”, which contains information on the company (e.g. financial data, management team background, plans on proceed usage, and other pertinent information).
• Step 3. Submit S-1 Filing → The pricing of the offering is arguably the most important decision because the offering price is perhaps the most influential determinant of investor demand. The terms surrounding the IPO, such as the offering price and listing date are largely predicated on the interest level of institutional investors, as their participation is crucial to the underwriting process. Therefore, a lack of interest from institutional investors can result in adjustments before the final S-1 filing is submitted to the SEC (or the IPO could even be scrapped if the demand is too bleak and market conditions are too unfavorable).
• Step 4. Obtain Formal SEC Approval → The formal approval and sign-off on the S-1 filing from the SEC is mandatory before the company’s shares can be distributed into the open markets. Once approval is obtained from the SEC, the underwriting process can proceed with the distribution of shares.
• Step 5. IPO Share Issuance → Once shares are officially issued, the company’s IPO is technically complete, and it is now recognized as a publicly traded company. But the underwriters must continue with their efforts to ensure all the stock issuances are sold and to stabilize the price, if necessary, i.e. minimize the price volatility.

What is the Underwriting Process in an IPO?

The underwriter of most IPOs, aside from those at the very bottom range in size, are offered to the public through a syndicate of underwriters.

The group of underwriters works with the issuer to structure the issuance, with the risk spread across various firms, instead of concentrated on one investment bank.

But while there are likely numerous investment banks advising on the deal, there is typically a “lead underwriter” with more responsibilities and influence than the other advisory firms.

Together, the underwriters of the IPO must structure the offering and settle on the terms. In particular, the offering price must be set appropriately, where the maximum amount of capital is raised (i.e. no money is left on the table) and there is sufficient demand in the market.

Learn More → Investment Banking Guide

What is the SEC S-1 Filing Requirement for IPOs?

For a private company to successfully undergo an initial public offering (IPO), the specific requirements established by the Securities and Exchange Commission (SEC) must be met.

The core documentation filed with the SEC is the S-1 registration statement, which is composed of two parts:

1. Prospectus → The first part of the S-1 contains the legally required information detailing the sale of the securities. The prospectus must describe the company’s business segments, an overview of its operations, audited financial statements, risk factors, the background of the management team, and any material information of relevance to potential investors.
2. Information Not Required in Prospectus → The second part of the S-1 contains discretionary information that the company is not required to report to investors, yet must file with the SEC.

The table below describes the key sections of the S-1:

What are the Benefits of an IPO? (“Going Public”)

Undergoing an IPO (i.e. “going public”) provides numerous advantages to the company and to its existing investors.

• Access to Capital → First and foremost, an initial public offering (IPO) represents an opportunity to raise a significant amount of capital, which in turn, is utilized to continue funding a company’s operations and its strategies to reach its next growth stage (and obtain more market share).
• Liquidity Event → From the perspective of management and existing pre-IPO investors, the IPO can be a liquidity event. While the IPO is an opportunity for management to “take some chips off the table”, venture firms and growth equity investors often must liquidate all of their positions, irrespective of their long-term thesis on the company’s prospects. The pre-IPO company, in all likelihood, is backed by venture investors and growth equity investors, so the IPO is an liquidity event, albeit there are restrictions on the timing of when those shares can be sold (i.e. the lock-up period). Venture capital firms and growth equity firms, at the end of the day, are investing on behalf of their limited partners (LPs), so the positions must be exited after the lock-up period and the sale proceeds are then distributed back to the LPs. An exit via an IPO is not necessarily an immediate exit, per se, since there is a lock-up period in which existing shareholders are prohibited from selling their shares for a period spanning between 90 to 180 days.
• Improved Branding → As a side benefit, the company’s branding tends to benefit substantially post-IPO, especially from investors interested in potentially owning shares, which indirectly expands the company’s name recognition and makes it easier to attract (and retain) more qualified employees. For example, widespread coverage of the company’s stock in the media can potentially increase its sales from the positive impact on its brand perception.
• Lower Cost of Capital → By becoming a publicly-traded company, a company can potentially benefit from having access to cheaper forms of capital, e.g. corporate lenders will typically then be able to offer debt financing at a lower interest rate with more favorable terms.

What are the Risk of an IPO?

The benefits of becoming publicly traded, especially from a monetary perspective, are relatively straightforward. However, there are several downsides that management must weigh when contemplating the decision to either go public or remain private.

• Less Control → The primary risk to management is the company—by virtue of becoming a public company—is no longer under their complete ownership and control. The new shareholders are partial owners in the company and if a sizable percentage of the shareholder base is displeased with the management team and the company’s financial performance, management is at risk of being voted out and replaced.
• Disclosure Requirements → The disclosure requirements as part of going public is meant to provide full transparency of the internal workings of the company, which opens management up to public scrutiny by investors. In addition, the company’s closest competitors can access their filings such as their financials and plans to achieve future growth. The scrutiny from the markets, equity analysts, and the media can serve as a distraction to the management team and employees.
• Near-Term Oriented: The quarterly filings (10-Q) place more pressure on the management team to meet short-term earnings targets (i.e. earnings per share) and other performance metrics tied to revenue or EBITDA, for instance. Hence, management’s decisions can become short-term oriented due to the external pressure from shareholders and the market to meet their quarterly or annual earnings guidance and targets set by external parties (e.g. equity research analysts).
• Costly Process → The process of going public can be a lengthy process, where the company incurs significant costs, such as advisory fees paid to the investment banks, legal fees paid to lawyers, and other fees paid to third parties like auditors and consultants. The regulatory hurdles, stringent compliance requirements, and disclosure requirements all contribute to the need to hire such advisors and third parties to help arrange the proper paperwork, which of course, all come at significant costs considering the high stakes.
• Operational Disruption → The disruption to the company’s day-to-day operations is yet another factor that must be taken into account. The IPO process can meet unexpected, time-consuming hurdles that can extend the time from announcement to becoming a public company. In that stretch of time, employees can easily become distracted by the media coverage, while management is likely occupied with the entire ordeal of the IPO requirements. The reason all of that matters is that the quality of the company’s products and services can suffer, resulting in less revenue and lower margins from operating inefficiencies.
• Reporting Requirements → The reporting requirements associated with becoming a public company mean more time, effort, and capital must be spent on ensuring compliance with the strict rules established by the SEC. Further, the consequences of not complying with the SEC can result in significant fines and penalties.

IPO vs. Direct Listing: What is the Difference?

In recent years, more companies have opted to go public through a direct listing, as opposed to via an IPO. The direct listing process bypasses the time-consuming, costly underwriting process, as a team of underwriters is not necessary.

The traditional advisory services from an investment bank, such as pricing guidance and stabilization efforts, are not needed because the company in such a case decides to rely on the market to determine the price.

There are significant risks attached to the decision to go public via a direct listing, where the upside and downside are both magnified. Significant price volatility tends to be a characteristic inherent to direct listings, irrespective of the outcome.

Generally, a direct offering tends to only be feasible for companies with a well-known brand, where investor interest is already practically guaranteed.

For instance, Spotify (NYSE: SPOT) decided to proceed with the direct listing route at a time when the company was already the market leader in the music streaming vertical. Thus, the anticipation from investors for the IPO was high, while the overall market sentiment was very optimistic.

The notable benefits of going public via a direct listing are as follows.

• No (or Less) Dilution
• No Lock-Up Period
• Cost Savings (i.e. No or Minimal Advisory Fees)
• Supple / Demand Auction-Based Process
• Increased Liquidity

To reiterate, however, a direct listing remains the riskier option, as the process is relatively new, and because there is no assurance that the shares will be priced “correctly” by the market or that a sufficient number of shares will be sold.

Criticism of Traditional IPO Process (Bill Gurley)

The shares of newly public companies often surge on the first day of trading, with the market capitalization (i.e. equity value) rising in excess of $50 to $80 million on the first day.

The delta in the IPO offering price and the market share price is the source of much criticism, where investment banks are accused of intentionally underpricing IPOs (and “leaving money on the table”).

However, one must consider that the underwriter must make sure all shares are sold, rather than solely maximizing the valuation. Striking the right balance between the two is easier said than done, and the same applies to predicting demand from the retail market.

With that in mind, the underpricing of an IPO can be attributed to the investment bank’s primary goal of selling all the shares offered in the issuance, i.e. the trade-off between offer price maximization and selling the entire issuance.

The more concerning claim is that investment banks intentionally underprice IPOs for their own self-interest, about building trust among institutional investors.

The fact that those institutions are also clients brings attention to a potential conflict of interest.

The post-IPO spike in the share price of a newly listed company represents profits to the investors (i.e. the institutional network of the investment bank) who participated in the IPO sale.

Given that one of the core functions of investment banking is managing relationships with institutional clients, there is valid reason for such criticism.

Suppose the IPO price was hypothetically priced perfectly, and the share price movement was non-existent (or even declined), then clients would not benefit from the share price appreciation.

On the other hand, an instantaneous rise in the share price post-IPO (and high returns) is likely to establish a long-term relationship with the institutional investor, with an increased probability of participation in future IPOs underwritten by the investment bank.

Therefore, many critics support direct listing instead of the traditional IPO. Venture capitalist Bill Gurley has held long-standing views that the discounted feature of the IPO is not a mistake, but rather a part of the business model.

^{“Putting Hot IPOs in Perspective” – Bill Gurley (Source: Above the Crowd)}