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The Initial Public Offering (IPO)

by Craig Moser on November 2, 2018

You have probably heard the term initial public offering, or IPO.  You probably know it’s a process that allows private companies to become public and sell shares in their firm.  But beyond that basic overview, do you understand IPOs?   Do you know why a company would want to become public?  Should you invest in an IPO?  To help answer these questions and more, here is a brief overview of IPOs.

What is an IPO?

When private companies want to sell shares of stock to the public, they do so through an IPO.  The IPO raises money which the company then reinvests in itself, or uses to expand business.  The process usually takes three or four months.

Other benefits of an IPO include employment incentives (offering stock option plans) or using stock as partial payment in merger and acquisition deals.

Underwriting an IPO

When a company goes public, it usually hires an investment bank (or banks) to handle the IPO.  Banks submit bids outlining how much money the company makes and how much the bank makes.  This is the underwriting process.  The underwriting agreement outlines specifics like  how much money the IPO will raise, what type of securities are issued, etc. are detailed in the underwriting agreement.

The registration statement is filed with the Securities Exchange Commission (SEC).  It includes financial statements, management background, where money is used, who owns stock before the company goes public, and if there are any legal problems.  The SEC conducts a thorough investigation and ensures everything submitted is complete and accurate.

The Road Show

Assuming everything is fine, the SEC works with the company and sets a date for the IPO.  The underwriter creates a prospectus and presents it to prospective investors.  Known as the “road show”, it stirs up interest, and is usually for bigger institutional investors rather than individual investors.  Known as an IPO allocation, investors can purchase shares during the road show, before the stock is listed on an exchange.  

Which Exchange Gets the New Stock?

Exchanges want business.  The Nasdaq and NYSE make sales pitches as to why their exchange is best for the IPO.  The underwriter and IPO company work together and decide which exchange to use.

How IPOs Work

IPOs generate a lot of attention.  However, there are unique considerations when it comes to investing in IPOs.  IPO stock can be especially unpredictable on its first day (and for the first few months.)  Therefore, you need to carefully weigh any IPO opportunities against your unique goals and tolerance for risk.  Make sure you understand how the IPO works.

Extracting long-term value out of an IPO is tricky.  For example, suppose you purchase shares of an IPO on its first day of trading for $20 per share.  By the end of day one, the price has risen to $30 per share.  Initially you think you’ve won the lottery, but that depends on your goals.

This scenario usually means stock was initially priced too low, and the company missed the opportunity to generate initial capital.  So, if you’re looking for short-term profits, it was a very successful day.  Conversely, pricing an IPO incorrectly isn’t in the best situation for long-term investors.

Do Your Research

Like any investment, do your research and know the product.  Consider your investment goals with an analysis of the company and its chances for growth.  Each IPO is unique, and there are unique risks.  Evaluate each IPO individually to determine its investment potential.

One challenge in researching a company is access to information.  In the US, private companies don’t disseminate financial information on a quarterly basis like public companies.  For this reason, it’s often difficult to fully assess if the company is a sound investment for you.  Your key source of information for the IPO is its prospectus.

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