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The Underwriting Process
Getting a piece of a hot IPO is very difficult, if not impossible. To understand why, we need to know how an IPO is done, a process known as underwriting.
When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required - it's just the way Wall Street works. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters as middlemen between companies and the investing public. The biggest underwriters are Goldman Sachs, Credit Suisse First Boston and Morgan Stanley.
The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.
Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the SEC. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used and insider holdings. The SEC then requires a cooling off period, in which they investigate and make sure all material information has been disclosed. Once the SEC approves the offering, a date (the effective date) is set when the stock will be offered to the public.
During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue. They go on a road show - also known as the "dog and pony show" - where the big institutional investors are courted.
As the effective date approaches, the underwriter and company sit down and decide on the price. This isn't an easy decision: it depends on the company, the success of the road show and, most importantly, current market conditions. Of course, it's in both parties' interest to get as much as possible.
Finally, the securities are sold on the stock market and the money is collected from investors.
What About Me?
As you can see, the road to an IPO is a long and complicated one. You may have noticed that individual investors aren't involved until the very end. This is because small investors aren't the target market. They don't have the cash and, therefore, hold little interest for the underwriters.
If underwriters think an IPO will be successful, they'll usually pad the pockets of their favorite institutional client with shares at the IPO price. The only way for you to get shares (known as an IPO allocation) is to have an account with one of the investment banks that is part of the underwriting syndicate. But don't expect to open an account with $1,000 and be showered with an allocation. You need to be a frequently trading client with a large account to get in on a hot IPO.
Bottom line, your chances of getting early shares in an IPO are slim to none unless you're on the inside. If you do get shares, it's probably because nobody else wants them. Granted, there are exceptions to every rule and it would be incorrect for us to say that it's impossible. Just keep in mind that the probability isn't high if you are a small investor.
Next: IPO Basics: Don't Just Jump In »
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