Is your private business having difficulty raising capital? Do you want to go public but need to understand the risks?
Hi, I’m AJ! I recently sold my business for multiple seven figures. Now, I help other entrepreneurs find success through Small Business Bonfire.
Throughout my business journey, I’ve learned about the benefits and risks of going public through an Initial Public Offering (IPO).
Many private companies are unaware of the advantages an IPO can offer. So keep reading if you’re ready to learn more!
What is an IPO (Initial Public Offering)?
An initial public offering (IPO) is the process of offering shares of stock from a private corporation to the public.
When private companies issue IPOs, it is the first time the public can access the business’s stock.
When companies transition from private to public entities, it allows early investors to see their investment gains.
Typically, initial public offerings include shares of stock from the current investors in the private company.
Lastly, IPOs allow public investors to purchase shares for the first time!
How Does an IPO Work?
How does an initial public offering work?
That’s an excellent question!
Before an IPO, a business is private, meaning shares of its stock are only available to private investors and not on the stock market.
So, as a pre-IPO private business, shareholders in the company typically include the following groups of people:
- Founders of the business
- Family members of the owners
- Venture capitalists
- Angel investors
As the private company grows, it eventually becomes mature enough to handle Securities and Exchange Commission (SEC) regulations.
At this point, the company decides to go public and will advertise this to the public.
For a business to be “ready” to go public, it (usually) must meet the following checkpoints:
- It has a private valuation of about $1 billion (this is not the case for all companies)
- Have strong fundamentals
- Have proven profitability potential
When the company determines it’s time to go public, the private share ownership converts to public ownership.
Additionally, the existing private shares become worth the public trading stock price.
Because the previously private company now offers shares on the stock market, more investors can buy shares and raise capital to a business’s shareholders’ equity.
Who does the public refer to in this case? Individuals and institutional investors who are interested in investing in the business!
Put simply, an initial public offering is an excellent way for private companies to expand and grow with the public’s help.
Why Do Companies IPO?
There are several reasons businesses choose to undergo the IPO process.
Regardless of the reasoning, an IPO is a significant step for any company.
Typically, companies do an IPO because it gives them access to raising more money.
As a result, the business can grow and expand faster because investment banks and individuals purchase shares of stock.
Also, this is a great way for companies to fund research and development efforts, new products or services, pay off debts, and more.
Furthermore, an IPO can attract potential future employees because of the stock options they may offer to their employees.
Lastly, IPOs are a visible way for companies to ‘go public’ with information about the company.
Investors can view the company’s financials and have a better understanding of its growth potential.
As you can see, a company can choose to go public and offer an IPO for numerous reasons!
History of IPOs
Who offered the first IPO?
While IPO has been a famous phrase amongst people involved in the stock exchange for years, the Dutch are credited with the first modern IPO.
That said, the Dutch conducted the first IPO by offering the Dutch East India Company shares to the general public.
After the Dutch allowed the public to purchase shares of their company, numerous other companies have used the technique to raise capital through public investors.
As people from the public buy shares of stock, it serves as an insurance of public share ownership.
The history of initial public offerings has seen uptrends and downtrends regarding the number of shares companies issue.
Factors in the economy and innovation have impacted these uptrends and downtrends.
Still, one industry that has seen a massive increase in IPOs is the tech industry.
Startups in the tech industry (typically) have little revenue.
During the dot-com boom, several tech startups joined the stock exchange by offering IPOs.
However, when the 2008 financial crisis struck, there were fewer IPOs than ever before.
For a while, new listings were rare.
Then, as the economy began to repair itself, the IPO buzz started to regain traction.
Today, IPOs are more common than ever, with numerous companies issuing IPOs every year.
Key IPO Terms
Here are some essential terms you must know when getting into IPOs!
Let’s take a look!
Common stock is a type of security that represents ownership in a corporation.
Holders of common stock exercise control by electing a board of directors and voting on corporate policy.
Further, common stock shareholders are at the bottom of the priority ladder for ownership structure.
In the case of liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders, and other debt holders have been paid in full.
However, common shareholders are entitled to their proportionate share of a company’s residual profits as dividends.
Also, these shareholders have the potential for capital gain if the company’s shares increase in price.
Common stock is a way for individuals to own a part of a company and share in its profits and growth.
The issued price is the initial offering price of a company’s stock when it chooses to go public.
An IPO can list below the issue price, also known as an IPO listed at a discount.
That said, the IPO listing price is significantly impacted by the supply and demand of the company’s shares.
Several factors impact the issue price, including the following:
- Industry comparables
- Growth prospects
- History of the company
- Time the shares were listed
- State of the economy
Lot size refers to the number of shares traded on an exchange.
Typically, lot sizes are determined by stock exchanges and vary from company to company based on their listing rules.
Since investors purchase lots, understanding how many IPO shares make a lot is crucial to calculating potential investments.
A preliminary prospectus is an initial draft of a registration statement that a business files before proceeding with an IPO.
The document is filed with the Securities and Exchange Commission (SEC).
Further, the purpose of a preliminary prospectus is to provide critical information to potential shareholders about the following things:
- The company’s business
- Managers of the company
- Strategic initiatives
- Financial statements
- The ownership structure of the business
The price band is the range within which a company can issue its IPO shares.
The issuer and underwriters determine the price band before the launch of an IPO.
Typically, the company announces a price band before filing its initial public offering with the Securities and Exchange Commission (SEC).
A preliminary prospectus, as well as media coverage, will circulate the price band.
The issuer and its book runner (underwriter) decide on the share allotment within this band.
An underwriter is any party that evaluates and assumes another party’s risk in the following things:
Typically, an underwriter collects a fee for their services in any of the following forms:
Essentially, underwriters calculate risk and determine whether an IPO is worth its price.
Underwriters can also help companies sell their stock on the public exchange.
SPACs and IPOs
IPOs and SPACs are ways for private companies to go public.
However, there are some differences in these two processes.
As previously mentioned, an initial public offering (IPO) observes a private business issuing new shares and selling them on the public exchange.
In a Special-Purpose Acquisition Company (SPAC) transaction, the private business becomes publicly traded by merging with a shell company.
Compared to an IPO, the advantages of going public through a SPAC merger include the following reasons:
- It’s faster: A SPAC merger typically takes about three to six months, while an IPO takes between 12 and 18 months.
- Upfront price discovery: You negotiate the stock price before the transaction closes with a SPAC merger, while the IPO price depends on market conditions.
- Lower marketing costs: A SPAC merger doesn’t require generating interest from investors in public exchanges.
- Access to operational expertise: SPAC sponsors are more experienced in the financial and industrial realms and can access a reliable network to help the company.
Still, there are some downsides to SPAC mergers.
For instance, the target company usually doesn’t have an underwriter in these cases.
Therefore, ensuring a business follows all the regulatory requirements is more challenging.
Also, SPAC mergers perform financial diligence on a narrower scope.
For example, because SPAC mergers don’t demand the same due diligence as an IPO, they are at risk of the following things:
- Potential restatements
- Incorrect business valuations
What Is the IPO Process?
Usually, the IPO process consists of two parts.
First is the pre-marketing phase of the public offering.
During this stage, companies advertise to underwriters by offering private bids.
Alternatively, businesses interested in going public can make a statement to the general public to generate interest.
After this, the underwriter leads the IPO stages.
Sometimes, businesses hire multiple underwriters while other companies only need one.
Because IPOs have several moving parts, hiring multiple underwriters is an excellent way to ensure each aspect is done correctly.
Further, the underwriters are involved in each aspect of the IPO, including:
- Due diligence
- Document preparation
The second stage of the IPO process is when the business offers IPO stocks to the public.
Steps to an IPO
As previously mentioned, IPOs are a lengthy process, typically taking between 12 and 18 months.
During this time, there are eight steps a business goes through before an IPO.
Let’s look at each of these steps in greater detail!
Step 1: Proposals
The first step is preparing proposals.
At this stage, underwriters present proposals and valuations that list the following details:
- The underwriter’s services
- The best type of security to issue
- Offering price
- Number of shares
- Estimate time frame for the market offering
These proposals allow the company to compare and contrast various services.
Additionally, the first step gives private companies an inside look at what to expect when going public.
Step 2: Underwriter
Step two officially selects an underwriter to work with through the transition process.
Also, during this stage, the business formally agrees to the terms presented in the underwriting agreement.
This stage is a decision and legality phase.
A business selects the best underwriter for their needs and ensures all their legal bases are covered!
Step 3: Team
The third stage in this process is creating IPO teams.
For instance, a company should create the following teams:
- Certified public accounts (CPAs)
- Securities and Exchange Commission (SEC) experts
Forming these teams ensures every aspect of the IPO goes smoothly.
Additionally, surrounding your business with teams of professionals allows you to make informed decisions and proceed in the best way possible.
Step 4: Documentation
Next, a company must compile information about itself into the required IPO documentation.
This documentation is called the S-1 Registration Statement, and it is the primary IPO filing document.
The S-1 Registration Statement has two parts:
- The prospectus
- The privately held filing information
Further, the S-1 includes basic information about the expected date of the filing.
Also, this document is continuously revised throughout the pre-IPO process as certain aspects change.
Step 5: Marketing
The fifth step is marketing and updates.
During this step, the company and its teams create marketing materials to pre-market the new stock issuance.
Then, the underwriters and executives promote the share issuance to estimate the demand from early investors.
Depending on the demand, the teams then create the final offering price.
Throughout the marketing phase, underwriters will make revisions to their financial analysis, such as changing the following aspects:
- IPO price
- Issuance date
- Supply and demand
Before the IPO, the business must follow the exchange listing and SEC requirements for public companies.
Step 6: Board Processes
The sixth step involves a company forming a board of directors.
This board of directors must ensure the processes for reporting auditable financial and accounting information each quarter.
Essentially, the board of directors helps keep the financial aspects of the business intact!
Step 7: Shares Issued
Now, it’s time for the company to actually issue its shares!
Companies issue shares on a designated IPO date.
Also, the capital from the primary issuance is received as cash and documented as stockholders’ equity on the company’s balance sheet.
As a result, the balance sheet’s share value relies on the company’s stockholders’ equity per share.
Step 8: Post IPO
Many assume the IPO process is finished after a business issues stock and becomes a public company.
However, there are some post-IPO details to complete!
For instance, one provision may determine that underwriters can have some time to buy additional shares after the IPO date.
On the other hand, some retail investors may be subject to quiet periods.
The quiet period prevents management teams or marketing agents from expressing opinions about the company’s value.
If company insiders disclose such information, they can be under penalty of the law.
Each post-IPO process is different depending on the company in question!
Advantages and Disadvantages of an IPO
The main goal of an IPO is to raise equity capital for a business.
Although this can be good for companies and potential investors, there are pros and cons.
Let’s take a look.
Advantages of an IPO
The primary advantage of an IPO is that a business can get investments from the entire public.
Therefore, anyone or any entity that is interested in a public company can buy its stocks.
As a result, companies can enjoy the following things:
- Easier to facilitate acquisition deals and share conversions
- Increased company exposure
- Better prestige and public image
- Higher chance of increased sales and profits
Another benefit of an IPO is that the company is more transparent (because it is public and not private).
As a result, the business must release quarterly reports about their financial status.
Increased transparency (typically) helps companies access more favorable credit borrowing terms from an investment bank compared to private businesses.
Public businesses receive better credit borrowing terms because their financial state isn’t a secret, allowing the investment bank to know what they’re getting into.
Some additional advantages of an IPO include the following things:
- Businesses can raise additional funds through secondary offerings in the future
- IPOs attract better management and skilled employees through liquid stock equity participation
- IPOs can provide a company with lower costs of capital for equity AND debt
Disadvantages of an IPO
Although an IPO has several advantages, there are some downsides to know about.
For example, the primary downside of an IPO is that it’s expensive.
Also, the costs of maintaining a public business compared to a private one are ongoing and are sometimes unrelated to the costs of doing business.
Further, the natural fluctuation of stock prices can distract management teams, whose compensation may rely on these rates.
Another disadvantage is that the company must disclose a lot of information, including:
- Financial results
- Other business information
As a result of sharing this information, a business could reveal secrets to its success that could help competitors.
Some additional downsides of an IPO include the following things:
- High legal, account, and marketing costs (which are ongoing)
- Management must spend more time, effort, and attention to report company financials and happenings accurately
- The business loses some control over its operations
If dealing with an IPO doesn’t sound right for your business, there are a couple of alternatives to consider.
These alternatives include:
- A direct listing
- A Dutch auction
Here’s what you need to know about each of these options!
A direct listing takes underwriters out of the equation.
Therefore, because direct listings skip the underwriting process, the business is at greater risk if the offering fails.
However, if the listing succeeds, the issuer can enjoy a higher share price.
Direct listings are best for companies with well-known brands and fast-growing businesses!
A Dutch auction is when the company does not set an IPO price.
Instead, potential buyers bid for the stock they want and name the price they’re willing to pay for it.
Then, the bidders willing to pay the highest price get the available shares!
Investing in an IPO
Before investing in an IPO, there are a few things individuals and institutional investors must be aware of.
While it’s possible to gather company information from news headlines, the primary source for information should be the prospectus.
Remember, the prospectus is available as soon as the company files its S-1 form.
Regarding the prospectus, individuals should pay attention to the following things:
- The management team and their commentary on the deal
- Quality of the underwriters
- The company’s financials
- The specifics of the IPO deal
Usually, big investment banks support a successful IPO, so be on the lookout for that.
Lastly, the most popular way individual investors can get IPO stock is through a brokerage platform.
Therefore, individuals must create an account with the brokerage firm selling shares of the stock they want and receive them that way.
Performance of IPOs
Here are some aspects that impact the performance of a traditional IPO!
After a few months, several IPO stocks take a significant downturn because the lock-up period expires.
The lock-up period prevents underwriters and company insiders from selling shares of stock for a specific period.
Federal securities laws state this period must be at least 90 days.
After lock-up periods, a rush of people try and sell their shares simultaneously.
Excessive supply puts downward pressure on the initial price.
A waiting period sets aside some shares for purchase after a specific time.
As a result, the company can raise additional capital because the price increases if underwriters purchase the shares.
However, the price decreases if underwriters do not purchase these shares.
Flipping is when people resell an IPO stock in the initial days on the open market to earn a quick profit.
This practice is expected when the stock is discounted initially and increases significantly on its first day of trading.
When a business spins off part of its company as a standalone entity, it creates tracking stocks.
Companies do this because a division can be worth more than a whole.
Individuals and investment banks like tracking stocks because a company’s spin-off experiences less initial volatility.
Final Thoughts on IPOs
An initial public offering (IPO) is when a privately held company goes public.
Companies go public for several reasons, the most popular one being that it is an easier way to raise money.
Is your company considering the transition from private to public? Let us know your questions about the process in the comments section!