As the global economy shifts to a more remote-based work environment, investors have speculated that many startups would announce an IPO (initial public offering). As venture capital and other private equity financing is becoming scarce, IPOs are more popular than ever.
Also known as “going public” there are many reasons why a business decides to launch an IPO. The most obvious is to raise capital. Another is to increase brand visibility, develop additional capital avenues, and rearrange the business model.
Whatever the cause, going public can be a grueling and time-consuming procedure.
What is the IPO Process?
IPO stands for Initial Public Offering. The IPO process happens when a previously unlisted company sells securities (new or existing) and offers them to the public for the first time.
Until this happens, a company is considered “private.” In other words, they have a small number of shareholders that are limited to accredited investors. This includes everything from venture capitalists and angel investors, to high net worth individuals and/or early investors (like the founder, friends, and family).
After the IPO, the company becomes public and is listed on the new york stock exchange (NYSE). It is no longer a private company. It is now part of the stock market, opening it up to stakeholders with different stock options and other capital markets.
So, what is the IPO process all about? Here’s a step-by-step playbook of how a company goes public:
The Step-by-Step IPO Process
- Choose Your Underwriter
- Due Diligence
- The IPO Roadshow
- Pricing the IPO
- Going Public
- IPO Stabilization
- Transition to Market
Step One – Choose Your Underwriter
Underwriting is a process in which an investment bank (the underwriter) acts as a broker between the issuing company and investing public. This is to help the issuing company sell its initial set of shares.
The investment bank will guide a business through the IPO process, advise you on becoming a public company, and provide the necessary underwriting services.
These financial institutions are registered with the SEC (Securities and Exchange Commission). Investment bankers are also IPO underwriters who work alongside your company during the entire process.
The underwriter is responsible for determining the initial offer price, buying the shares from the issuing company, and then selling those shares to investors. The bank typically has a network in mind of potential investors for the initial sale of shares.
Key Considerations for Selecting Your Underwriter
When choosing the best underwriter, here are a few things to consider:
- Industry expertise – How long have they been doing this?
- Quality of research – This includes in-depth financial reporting
- Reputation – What do others have to say about them?
- Network reach – Institutional investors or individual investors?
- Your prior relationship with the bank – Have you worked with them before?
- Connection to other companies – Who else have they worked for?
Underwriting an IPO can be a tedious and lengthy process. It requires time and money from a team of experts. However, choosing the right investment bank is a critical step. A talented underwriter can mean the difference between a successful IPO and a failure.
Step Two – Due Diligence
Now it’s time to get your hands dirty. This is the stage where a lot of paperwork, research, and due diligence is involved. Here are the underwriting arrangements available to an issuing company:
Firm Commitment
In this type of agreement, the underwriter purchases the whole offer and resells the shares to the general public. This is a short-term sale that guarantees the issuing company a certain amount of money will be raised.
All or None Agreement
This promises the issuing company that unless all offered shares are sold, the offer is canceled.
Syndicate of Underwriters
Public offerings can be managed by one underwriter or several. When there are multiple parties, one investment bank is chosen as the lead. This deems them the manager that runs the books.
With this agreement, the lead bank forms a syndicate of underwriters by creating strategic alliances with other banks. Each of these entities then agrees to sell a part of the IPO. This type of agreement arises when the lead bank wants to diversify the risk of an IPO among multiple banks.
Best Efforts Agreement
In this type of agreement, the underwriter does not guarantee any particular amount they will raise for the issuing company. The figure is left open. The underwriter only agrees to sell the securities on behalf of the company.
Regulatory Filings
Once an agreement has been reached, the underwriter is expected to draft the following:
Engagement Letter
This type of document includes a reimbursement clause and a gross spread/underwriting discount.
Reimbursement Clause
The reimbursement clause mandates that the issuing company must cover all out-of-pocket expenses that are incurred by the underwriter. This is the case even if the IPO is withdrawn during the due diligence, registration, or marketing stage.
Gross Spread / Underwriting Discount
The gross spread = the sale price of the issue sold to the underwriter minus the purchase price at which it was bought by the underwriter
Usually, the gross spread is a fixed amount at 7% of the proceeds. This is especially the case if there is high market liquidity.
The gross spread is used to pay a fee to the underwriter. If there is a syndicate, the lead bank is paid 20% of the gross spread. 60% of the remaining spread (referred to as “seller concession”) is split between the syndicate of underwriters in proportion to the number of issues sold. The remaining 20% is used to cover expenses like roadshow and underwriting counsel.
Letter of Intent
This type of document typically includes commitments and an overallotment option.
Underwriter’s Commitment
This is when the underwriter enters into an underwriting agreement with the issuing company.
Issuing Company’s Commitment
This is a commitment by the issuing company to provide the underwriter with all relevant data and fully cooperate in all due diligence efforts.
Overallotment Option
This is an agreement by the issuing company to provide the investment bank with a 15% overallotment option.
The letter of intent remains in effect until the pricing of the securities. After this, the Underwriting Agreement is executed. When this occurs, the underwriter is contractually bound to purchase the issue at a specific price.
Registration Statement
After the details have been agreed upon, the U.S. Securities and Exchange Commission (SEC) requires that the issuing company and underwriter(s) file a registration statement. This document consists of:
- Information regarding the IPO
- The company’s financial statements
- The background of the management team
- Insider holdings
- Any legal problems the issuing company faces
- The ticker symbol to be used once listed on the stock exchange
The registration statement has two parts:
- The Prospectus: This is given to every investor who buys the issued security. It consists of the details of the issuing company, except for the effective date and offer price.
- Private Filings: This is information provided to the SEC for inspection but not necessarily made available to the public.
This document ensures that all investors have adequate and reliable data about the securities. The SEC then carries out due diligence to ensure all necessary details have been properly disclosed.
Step Three- The IPO Roadshow
Now it’s time to sell the company to institutional investors and evaluate the demand for shares. Typically called “roadshows,” these events can last for 3 to 4 weeks and includes a sales pitch.
The issuing company and underwriter travel to various locations to present the IPO and market shares to investors. They can then evaluate interest to better estimate the number of shares to offer.
Step Four- Pricing the IPO
Once market demand is understood, the stock price must be set. The price is generally determined by the value of the company. This is done through a valuation process and occurs before the IPO process starts.
The SEC must approve the IPO. Then the effective date is set. The day before this happens, the offer price must be decided. This is the number at which stockholders can purchase shares from the issuing company.
The precise number of shares to be sold is also determined. Deciding this price is critical because this is the price at which the issuing company raises capital for itself.
Key Considerations for Pricing
When pricing an IPO, there are a few things to look at:
- Reputation of the issuing company
- The condition of the market economy
- The goals of the issuing company (i.e. amount of money to raise)
- Value of the issuing company
- Success/failure of the IPO roadshow
It is not uncommon for an IPO to be underpriced. When this happens, it’s because investors are expecting the price to rise and increase demand. It also works to reduce the risk entities take by investing in the IPO, which could potentially fail.
Going to public markets with a lower price ensures the issues are fully subscribed or oversubscribed by the public investors—even if the issuing company does not receive the full value of its shares. An offer that is oversubscribed two to three times is often considered to be a “good IPO.”
Step Five – Going Public
Get your press releases ready! This is the stage at which a company officially goes live. On the agreed-upon date, the underwriter will release the initial shares to the market. You can then monitor the Nasdaq, Dow Jones, or other analytics services closely.
Step Six – IPO Stabilization
Once a company has gone public, there is a period of time in which there are no rules preventing price manipulation. In this window of opportunity, typically a 25-day “quiet period” that occurs immediately after the IPO, the underwriter can influence the share price.
After the issue has been brought to market, the underwriter is responsible to provide analyst recommendations, after-market stabilization, and create a market for the recent stock issued. In the event of order imbalances, the underwriter helps to stabilize the market by purchasing shares at the offering price or below it. That’s why it’s so important to have good investment banking on your side!
In the stabilization period, the underwriter ensures there is a market and buyers to maintain an ideal share price. To do this, there are a few strategies:
Greenshoe Option
In the letter of intent, there is a clause that allows for the option of overallotment. This is also called the Greenshoe option and enables an underwriter to sell more shares than originally planned. The underwriter then buys them back at the original IPO price.
If the price of the shares decreases, the underwriter buys back the over-alloted shares. In this case, the bank makes a profit since the price is less than what they originally sold it for.
If the price of the share increases, the underwriter has the option to buy the share at the original IPO price, thus avoiding any losses. All of this is stated in the contract, under the allotment clause.
The Greenshoe option is a popular choice because it’s permitted by the SEC and is risk-free. While the legal term for this process is overallotment, the more common term is Greenshoe. That’s because Green Shoe Manufacturing (now known as Stride Rite) was the first company to successfully pull it off!
Lock-Up Period
When a company goes public, anyone who already owned shares can cash out. However, these shares can only be sold following a lock-up period.
This is a pre-determined amount of time (typically between 90 and 180 days) when insiders who owned shares before the company went public are not allowed to sell their stock. This avoids flooding the market with sales and driving the overall price down.
Stabilization activities can only be carried out for a short period of time. However, the underwriter has the freedom to trade and influence the price as they see fit. During this time, all prohibitions against price manipulation are suspended.
Step Seven – Transition to Market
After the 25-day quiet period mandated by the SEC ends, the final step—transition to market, begins. Now the underwriters and investors transition from relying on the prospectus to now tracking the market.
Everything is now considered public and out of the underwriter’s hands. The bank can only provide the company with estimates on earnings and post-IPO evaluation.
As the market shares fluctuate, the underwriter quickly moves into the role of an advisor. The responsibility to bring everything to the public is done.
Summing it Up
If you’re thinking about bringing your business public, understanding the entire IPO process is critical. There’s a reason a system is in place for going public. Everything must be done in order, otherwise, you risk serious fines from the SEC.
The most important step is finding an underwriter (or group of them) that you can trust. This entity will be your guide during the transition and ultimately become an advisor. With the right team and knowledge on your side, announcing an IPO should be a lucrative step in growing your business.
