Here’s what an IPO is, and how to explain all the related processes in simple terms
The success that awaits the company when it changes status from private to public one can be unbelievable. Indeed, representing the company’s shares on the largest exchanges in the world is not only prestigious, but also profitable. However, holding an IPO is not that simple, it is more about a lengthy and cumbersome process.
PaySpace Magazine decided to figure out what an IPO is, and how to explain all the related processes in simple terms.
IPO — what is it?
IPO (Initial Public Offering) is a type of public offering in which shares of a company are sold to institutional investors and usually also retail (individual) investors. An IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. In other words, if a company holds an IPO, it means this company goes public.
Reasons & aims
- To raise capital
Through an IPO, companies gain access to multiple investors all over the world. Moreover, financing does not require a return: the company does not borrow money, but receives it in exchange for a share in the business. It also becomes easier for public companies to obtain loans from banks and other financial institutions, since financial reporting becomes open in this case.
- To obtain an estimate
Stocks traded on the stock exchange provide the most accurate estimate of the value of the company. Such an assessment can be used in negotiations on mergers and acquisitions, and the company can pay for the purchase not with money, but with its own shares. The stock price is used to evaluate the work of top managers, as well as incentive stock options plans. Also, public status attracts more attention, makes a company more recognisable, and helps to work out marketing-related issues.
- One more way for early investors to guarantee the incomes
Venture investors who specialize in start-ups investments, and finance the company in the early stages, get the opportunity to cash their investments (and make even more profits from them). Sometimes investors sell part of their shares to new investors and put money in other companies (apparently, at early stages as well).
There are a lot of other reasons to start an IPO (provision of long-term projects, upgrading of equipment, debt repayment, acquisition of other companies, etc.), but we decided to list the major ones. Protection from possible takeovers (acquisitions) from other companies is one more possible reason for a company to go public. After entering the market, the company receives its market value, and also expands its capabilities in terms of capital, which significantly complicates the merger process. In addition, after an IPO, a company can take loans secured by its shares.
The first step before stocks enter the market is preparation. At this stage, important work is carried out to develop a strategy, an analysis of the company’s readiness to enter the market, and its compliance with all standards and requirements.
While the company is preparing for an IPO, it is necessary to create a so-called investment memorandum, which is a legal document that a company presents to potential investors to explain the objectives, risks, and investment terms surrounding a funding round.
To conduct an IPO, you need to find an underwriter, that is, a bank or several banks that will be involved in (underwriting) bringing shares to the market. Of course, a company can implement this process on its own, but in reality, no one does it this way. Most often start-ups turn to large banks for helping with an IPO. Underwriters invest in a company even before it becomes public. Thus, underwriting institutions “buy” shares before they go stock exchange.
You may ask “How can it be interesting/beneficial for them?” They earn on the difference between the stock price before the IPO and after. If everything goes cool, profits from such events can be enormous, especially taking into account the investment opportunities of large banks.
A roadshow can be the next step of a company. At this point, management travels around the world and holds presentations for potential investors: it talks about its business, prospects, and conditions of listing the shares. During the roadshow, prospective investors can place an order for shares. They tell the company’s representatives how many shares they want to buy, and what price they are ready to pay for them.
After choosing the stock exchange on which an IPO will be held, the final stage begins, and it is about carrying out an IPO per se. First and foremost, the final price per share has to be determined. Often, when the company’s shares enter the market, significant volatility is observed, as many investors tend to buy securities as cheaply as possible in the hope that their value will increase in the very near future.
Investors’ benefits and a lock-up period
The companies and underwriters value their reputation. They try to comply with the interests of all parties. It means they try to attract the maximum amount of capital and give investors the opportunity to earn. Therefore, the price of shares during placement is usually set with a discount (compared to the fair price). After an IPO is held, the price rises and investor earnings increase.
However, shares cannot be sold immediately after being listed. Here we face such a definition as lock-up period, which is the amount of time (usually 180 days), when the shares are “frozen”. More specifically, it is the period of time when large shareholders, such as company executives and investors representing considerable ownership, are restricted from selling their shares. Investors can sell the shares and get their money after the end of the lock-up period.