What is an IPO?

Fundamentals ·

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Before a company makes its way to the public market, it has to go through a complex and expensive procedure of Initial Public Offering (IPO).

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In this article, we'll look at how an IPO usually goes, why is it important, and why many mid-size companies are trying hard to achieve this significant milestone. We'll also talk about the advantages and disadvantages of going public for a company.

IPO Definition and Meaning

The term “IPO” is known to most of the market participants, investors, portfolio managers, and market analysts. Initial public offering (IPO) is simply a moment when a company goes public and makes its shares available to all potential buyers. Technically speaking, at first, a company puts its shares on the primary market which is accessible to a limited number of investors and only after that the shares go to the secondary market.

A private company becomes a publicly-traded company once it goes public through the IPO and this change in its status comes with a huge set of additional requirements such as better transparency, regular reporting, etc. As a result of an IPO, a company can raise significant capital which often makes its initial shareholders rich by allowing them to sell a portion of their stock.

How to Go Public?

Financial markets are usually regulated by the government institutions and the US is not an exception: there are a lot of regulations that are imposed by the SEC (Securities and Exchange Commission) and any company that intends to go public is forced to meet a certain number of requirements.

The IPO filing process is very complex so most of the companies delegate it to specialized investment banks. These banks often called “underwriters”, wouldn't work for free. Investment banks ask for a portion of a company's stock before an IPO so they can also benefit from a successful IPO which also adds more incentives for underwriters to do their job well.

Example of an IPO

Let's look at a hypothetical company, a successful chain of restaurants, which intends to go public. We'll assume that it has one initial owner with a 100% stake in the company. In order to expand its business, the company needs more money and there are few options to do so, one of which is conducting an IPO. Another option might be to get a loan (commercial credit) from a bank, but the ability to borrow from such sources has its limits and it can damage the company by exposing it to the additional interest payment expenses.

Let's imagine that the owner decided to go public in order to raise an additional $10,000,000 for business expansion.

Now, a bank has to understand how many shares should the owner sell and to assess whether it is even possible to get such an amount of money after an IPO (to determine that, a bank has to do a detailed company's evaluation), and lastly a bank should negotiate on its commission and a portion of shares.

Let's say that the bank A evaluated the total value of the company to be $50,000,000, therefore, in order to raise $10M, the owner has to sell 20% of his shares. The bank may propose to issue 1,000,000 shares at a price of $10 each ($10,000,000 capital). This would be the initial stock price at the moment of an IPO.

➤ Read also: What is Market Capitalization?

Some successful private companies might want to wait for a while before they go public, just to establish a well functioning corporation and to be prepared for the consequences which an IPO creates. No one forces companies to go public so they can remain private forever or they can patiently wait for the best time to go public.

When a company and an underwriter come to an agreement on the terms of an IPO, they have to submit the paperwork to the regulator. After the company goes public, its shares become available to everybody. Be careful though, according to the historical data, the price is as likely to go down as well as up so don't expect any hefty profits from blindly buying shares in newly public companies.

So, after the owner gets his money, he can expand his business further and sell more of his stocks later. Also, it's not uncommon to buy stocks back from the public market to strengthen the control over the company or to protect the company from an aggressive LBO (leveraged buyout).

Why Go Public?

IPO has its pros and cons and it's always up to the company management to decide if it's worth going public. Some public companies may even decide to go back to private ownership. 20 or 30 years ago it was believed that an IPO is a right choice for every company and that it will always go smooth resulting in a net positive outcome for everyone. However, some companies (like Walmart) kept their private form and the time has proven that IPOs are not for everyone. These days, many companies are weighing the pros and cons of a possible IPO more carefully.

Here are some commonly known advantages of an IPO:

  • Raising additional equity without taking debt
  • Improving the public image of a company and raising its reputation
  • Enabling a more diversified control of a company
  • Rewarding the management and other shareholders with additional income and capital gain

And here are some disadvantages to be considered:

  • A public company can't hide its numbers and has to expose all of its financial information to everyone
  • An IPO is a long process and it's expensive
  • There is a risk that an IPO will be a failure which can damage a company
  • Old shareholders may not like losing their grip on the company

Largest and Most Famous IPOs

  • In 2012, Facebook went public and it raised $16B.
  • In 2010, General Motors went public and it gained $18B as a result.
  • In 2008, VISA went public and it received $18B.
  • In 2010, ICBC (Industrial and Commercial Bank of China) got $21B from its IPO.
  • in 2014, the Alibaba Group was able to raise $25B after its IPO.
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