If a company decides to raise capital by issuing stock, it must file a formal registration statement with the Securities and Exchange Commission (SEC) that details the business's financial history, current financial situation, the proposed public issue and future projections. The company must also prepare a preliminary prospectus that contains information similar to that of the registration statement for potential investors. (Learn more about the regulation of IPOs in How The Sarbanes-Oxley Era Affected IPOs.)
After a 20-day waiting period, the registration statement is considered accepted unless the SEC sends a letter of comment asking for changes. The securities can be sold, and a final prospectus is issued at the conclusion of the waiting period. An investment bank will act as an underwriter to effect the sale, which is known as the initial public offering or primary offering. A primary offering is the first of issuance of stock for public sale from a private company. This is the means by which a private company can raise equity capital through the financial markets in order to expand its business operations.
A primary offering is usually done to help a young, growing company expand its business operations, but it can also be done by a mature company that still happens to be a private company. Primary offerings can be followed by secondary offerings, which serve as a way for a company that is already publicly traded to raise further equity capital for its business. After the offering and the receipt of the funds raised, the securities are traded on the secondary market, where the company does not receive any money from the purchase and sale of the securities they previously issued. The secondary market is where investors purchase securities or assets from other investors, rather than from the issuing companies themselves. The national exchanges - such as the New York Stock Exchange and the Nasdaq - are secondary markets. (Learn more in A Look At Primary And Secondary Markets.)
If the issue will be for less than $5 million, the company need only file a concise offering statement with the SEC. A sale to fewer than 35 investors is considered a private sale and eliminates the need to file a registration statement with the SEC. However, unregistered securities are not as easy to sell as registered securities. (For related reading, see Valuing Private Companies.)
A cash offer is one of two types of public issues. We'll discuss the other type, a rights offer, later in this section. A cash offer makes shares available to the general public in an initial public offering. But first, let's go over the differences between private and public companies.
A privately held company has fewer shareholders, and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company; just put in some money, file the right legal documents and follow the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private, too. Did you know that as of February 2012, IKEA, Domino's Pizza and Hallmark Cards are all privately held?
It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public." (Learn more about going public in IPO Basics: Don't Just Jump In and How An IPO Is Valued.)
Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors, and they must report financial information every quarter. In the United States, public companies report to the Securities and Exchange Commission (SEC). In other countries, public companies are overseen by governing bodies similar to the SEC. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market like any other commodity. If you have the cash, you can invest. The CEO could hate your guts, but there's nothing he or she could do to stop you from buying stock.
Why Go Public?
Going public raises cash - usually a lot of it. Being publicly traded also opens many financial doors:
- Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
- As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.
- Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.
- Being listed on a major stock exchange carries a considerable amount of prestige. In the past, only private companies with strong fundamentals could qualify for an IPO and it wasn't easy to get listed.
The Internet boom changed all this. Firms no longer needed strong financials and a solid history to go public. Instead, IPOs were done by smaller startups seeking to expand their businesses. There's nothing wrong with wanting to expand, but most of these firms had never made a profit and didn't plan on being profitable any time soon. (Read about what some analysts consider the second dot-com bubble in What To Expect From The Groupon IPO and What To Expect From The Zynga IPO.)
Founded on venture capital funding, they spent like Texans trying to generate enough excitement to make it to the market before burning through all their cash. In cases like this, companies might be suspected of doing an IPO just to make the founders rich. This is known as an exit strategy, implying that there's no desire to stick around and create value for shareholders. The IPO then becomes the end of the road rather than the beginning. (Not every dot-com company went bust. Read more in 5 Successful Companies That Survived The Dotcom Bubble.)
How can this happen? Remember: an IPO is just selling stock. It's all about the sales job. If you can convince people to buy stock in your company, you can raise a lot of money.
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 as of February 2012 are Goldman Sachs, Credit Suisse First Boston and Morgan Stanley. (For related reading, see Wanna Be A Bigwig? Try Investment Banking and The Rise Of The Modern Investment Bank.)
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 to be 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 it investigates and makes 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 initial share 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. (Read Investing In IPO ETFs to learn how you can get a piece of the IPO action.)
A lock-up agreement may restrict the stock's trading somewhat after the company goes public. A lock-up agreement is a legally binding contract between the underwriters and insiders of a company prohibiting these individuals from selling any shares of stock for a specified period of time. Lock-up periods typically last 180 days (six months) but can on occasion last for as little as 120 days or as long as one year.
Underwriters will have company executives, managers, employees and venture capitalists sign lock-up agreements to ensure an element of stability in the stock's price in the first few months of trading. When lock-ups expire, restricted people are permitted to sell their stock, which sometimes (if these insiders are looking to sell their stock) results in a drastic drop in share price due to the huge increase in supply of stock. (Learn more in IPO Lock-Ups Stop Insider Selling.)
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