This guide describes all the steps, processes, and scope of an Initial Public Offer.

 

1. What is an Initial Public Offer (IPO)?

 

An Initial Public Offering (IPO) is the first sale of stocks issued by a company to the public. Before an IPO, a company is considered a private company, usually with a small number of investors (founders, friends, family, and business investors such as venture capitalists or angel investors).

 

When a company goes through an IPO, the general public can buy shares and own a portion of the company for the first time. An IPO is often called “going public,” and the underwriting process is typically led by an investment bank.

 

1.2. Reasons Why Companies Go Through an IPO

 

Companies that are looking to grow often use an Initial Public Offering to raise capital. The biggest advantage of an IPO is the additional capital raised.

 

The capital raised can be used to buy additional property, plant, and equipment (PPE), fund research and development (R&D), expand, or pay off existing debt. There is also an increased awareness of a company through an IPO, which typically generates a wave of potential new customers.

 

1.3. Challenges From a Public Listing

 

Although there are benefits of going public, there are notable drawbacks to consider as well. An Initial Public Offering (IPO) can take anywhere from six months to a year. During this time, the management team of the company is likely focused on the IPO, creating a potential for other areas of the business to suffer.

 

Public companies are made up of thousands of shareholders and are subject to rules and regulations. A board of directors must be formed, and auditable financial and accounting information must be provided quarterly.

 

1.4. Company Valuation

 

Investment bankers spend much time trying to value the company going public. Ultimately it will be the investors who decide what the company is worth when they decide to participate in the offering and when they buy/sell shares after it starts trading on the exchange.

 

1.5. The main methods bankers use to value the company before it goes public are:

 

• Financial modeling (discounted cash flow analysis / DCF analysis)

• Comparable company analysis

• Precedent transaction analysis

 

By combining these three methods, bankers can triangulate what they think is a reasonable value an investor would be willing to pay for the business.

 

1.6. IPO Underpricing

 

Despite all the valuation work mentioned above, there is still a tendency for IPO underpricing to occur when companies go public (i.e., they are intentionally priced significantly lower than what the first-day trading price will be). For example, LinkedIn Corporation went public at $45 a share but traded as high as $122 at day end. This is often referred to as “leaving money on the table.”

 

Underwriting a public offering can be disastrous for a company. Assume Company A prices its one-million share IPO at $20 a share. If the shares end up trading at $40 a share, this will indicate that Company A received $20 million (1 million * $20) when it could’ve made $40 million (1 million * $40) if the IPO was not underpriced.

 

1.7. The following example can illustrate a popular theory in corporate finance as to why IPOs are underpriced:

 

Assume there are two categories of investors who invest in an IPO – insiders and the rest of the market (outsiders). Insiders know the actual value of the company and would stay away if it is overpriced. If the IPO is underpriced, insiders will purchase the shares.

 

Outsiders do not know the actual value of the company but know that the insiders know. With this knowledge, outsiders would follow suit with the action of the insider:

 

• If the IPO is underpriced, everyone will buy shares.

• If the IPO is overpriced, the insiders won’t buy. Knowing this, the outsiders will also not buy into the offering.

• Thus, it is in the best interest of the issuer and its bank to underprice the offering.