The Road to Creating an IPO

Through an initial public offering (IPO), a company raises capital by issuing shares of stock, or equity, in a public market. Generally, an IPO is a company's first issue of stock. But there are ways a company can go public more than once.

The IPO process is the locomotive of capitalism. It allows the investing public to own small shares in any of the many companies that have grown large and hugely successful since they first went public.

Issuing shares through an IPO is one of the primary reasons that stock markets exist. A company can raise capital for a variety of reasons, such as to fund its expansion, let early-stage investors cash out some of their investment, or create a currency (such as common stock) to acquire rivals.

The IPO process is referred to as the primary market as it enables investors to buy stock directly from the company. From then on, those shares exist in a secondary market, where investors trade among themselves with shares that have already been issued by the company.

  • An initial public offering, or IPO, is the first chance most individual investors get to buy an ownership stake in a young company.
  • For early-stage investors and insiders, it's a chance to cash in.
  • For the company, it's an opportunity to raise money for development and expansion.
  • In order to go public, a company must open its books to scrutiny by potential investors and financial regulators.
  • The company's prospectus and its executive "roadshow" offer a fuller look at the company's plans and prospects.

How Do IPOs Work?

The Process to Taking a Company Public

Getting a company through to its IPO takes time, is expensive, and must pass many regulatory hurdles. A very important component of going public is opening a firm’s books to public scrutiny, as well as the oversight of the Securities and Exchange Commission (SEC). 

An investment banker, or underwriter, will help a company through this process, and the younger associates at an investment banking firm will bear the brunt of the grunt work. Those associates will spend many sleepless nights preparing a preliminary prospectus for the SEC and investors, which has come to be referred to as a red herring.

The Final Prospectus

Through many revisions and discussions between the company and its bankers, the red herring will eventually become the final prospectus, which is the formal legal document filed with the SEC that lets the IPO process go through.

One of the most common prospectus documents is referred to as form S-1, the formal registration statement under the Securities Act of 1933. 

Other “S” versions exist and refer to different securities acts, such as those related to investment trusts, employee plans, or real estate companies. The prospectus may sound dull and can include hundreds of pages of seemingly mundane and redundant information. But it is extremely important for investors to understand what the company does, why it is issuing shares through an IPO, and what type of ownership structure is being offered.

IPO Costs

PwC, the professional services company, provides a summary of costs that a company can expect to incur to go public. It also illustrates the steps needed to complete an IPO. 

For starters, the underwriters, which generally include a lead underwriter and multiple other underwriters (also referred to as the sell-side firm and the lead “book runner” with co-managers), can take a cut of 4% to 7% of the gross IPO proceeds to distribute shares to investors.

For example, Goldman Sachs (NYSE: GS) was Twitter's (NYSE: TWTR) lead underwriter when Twitter went public in 2013. Together with other underwriters including Morgan Stanley (NYSE: MS) and JPMorgan (NYSE: JPM), they shared about $59.2 million, 3.25% of the $1.82 billion that Twitter raised in its IPO, for managing the sale.

The IPO Roadshow

There will also be legal, accounting, distribution, and mailing, plus roadshow expenses that can easily total in the millions of dollars. A roadshow is just what it sounds like. It involves company executives, including the CEO, CFO, and investor relations representative, hitting the road to build enthusiasm for investing in the IPO and explain their motivations for doing so. A successful road performance can drive demand for the stock and result in more capital raised.

In rarer circumstances, a roadshow can have the opposite effect. Back when Groupon went public, it came under fire from the SEC for an accounting term referred to as “Adjusted Consolidated Segment Operating Income."

The SEC, as well as other investors, questioned the manner in which it adjusted for marketing and advertising expenses and called into question how fast the company could grow or generate ample profits in the future.

The Role of IPO Underwriters

There are other terms to be familiar with in the IPO process. Through a greenshoe option, underwriters can have the right to sell additional shares or an over-allotment of shares.

This can occur if an IPO ends up having strong demand and it lets the bankers make additional profits, which are earned by selling the shares off at a higher price. It can also let the company earn additional capital.

Planning and Pricing an IPO

A tombstone refers to a summary advertising document that underwriters issue to prospective investors (and sometimes themselves to commemorate that the IPO process has been completed). It summarizes a prospectus and briefly introduces a company.

Underwriters also help companies determine price, or how to best balance the supply of shares being offered with investor demand. Of course, most companies will happily increase supply (such as through a greenshoe option) to meet higher demand, but a difficult balance must be reached.

A stock exchange, such as the New York Stock Exchange (NYSE), can help the process and indicate what an opening price on the IPO day is likely to be. Market makers and floor brokers help in this process, as does the syndicate of underwriters, to gauge the overall level of investor interest.

Deciding which exchange to use is also of the utmost importance. Most firms would prefer the NYSE or Nasdaq markets given their ability to transact billions of dollars of daily trading activity and a solid guarantee of market liquidity, trading execution, and follow-up reporting.

The Company’s Perspective

In addition to the cost considerations, a company must make many changes to survive when public. The prospectus stipulates many of the new financial, regulatory, and legal burdens, and PwC estimates that there are between $1 million and $1.9 million in additional ongoing costs to the average firm that goes public.

Hiring and paying a board of directors, or at least a higher profile board, can be expensive.

Sarbanes Oxley regulation also imposed cumbersome duties on public companies that must still be met by most larger firms.

Learning to deal with analysts, holding conference calls, and communicating with shareholders may also be a new experience.

Some investors get over-enthusiastic about the latest "hot" IPO. It might be smarter to wait to buy until it cools off a bit.

Is Buying IPO Stock a Good Idea?

For investors in general, it pays to be careful when investing in an IPO.

Most importantly, the company and underwriters have control over the timing of an IPO and will try to take the firm public under the most opportune circumstances. This could include timing it for a rising or bull market, or after the firm posts very favorable operating results.

A higher price is great for the company and bankers, but it can mean the investment potential in the future is less bright. The shares of many companies surge above the IPO price during the first day of trading, particularly those considered "hot."

The Waiting Option

A better strategy to consider may be to buy into an IPO later in the secondary market after the excitement has died down. A stock that falls in value following an IPO could indicate a pricing miscue by the underwriter, or potentially a lower price to invest in a solid company. 

An IPO usually refers to selling shares to the public for the first time. But a company can be taken private (such as by a private equity firm) and then be taken public again, which is also an IPO. This has occurred with Burger King several times.

The Bottom Line

Since capitalism has existed, investing in public companies has been an engine of capitalism that lets individuals invest in large firms that have created vast wealth for shareholders.

The process is complex, and investors need to be aware of IPO timing. But understanding the road to an IPO can be lucrative for companies, underwriters, and investors alike.

Article Sources
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  2. PwC. "Roadmap for an IPO: A Guide to Going Public," Page 60.

  3. U.S. Securities and Exchange Commission. "SEC Form S-1 IPO Investment Prospectus."

  4. U.S. Securities and Exchange Commission. "List of SEC Form."

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