IPO Explained

IPO Explained
IPO

From Private Company to Public Company: Everything You Need to Know About IPOs

Greetings! You've probably heard about IPOs before, but perhaps you’re a little sketchy on the details. An IPO is an acronym for initial public offering. Private companies that want to go public can apply to become listed on the stock exchange as they transition from private ownership to public ownership.

By going public, a private company offers shares (ownership rights) to shareholders in the market. Any private company can decide to go public (subject to qualification criteria). For example, an innovative start-up could decide to list on an exchange, thereby going public. Or, an established company may be able to expand operations, pay off debts, and raise capital by going public.

You may be wondering why a private company would want to go public and dilute ownership with the mass market? In effect, when a private company decides to go public, this is the beginning of a new company. The entire management operations of the enterprise change when it moves from private to public ownership. As a retail investor, IPOs present opportunities and risks to you.

Private firms need to grease the proverbial wheels of their daily operations with money. Precisely, where they get all their AUD from is up to the board. Private companies can apply for loans at the banks and financial institutions (short-term and long-term debt obligations), they can tap into the resources of their ownership (capital financing and other private investment), or they have the option of raising capital on the public markets via an IPO.

How do IPOs work?

Once the decision has been made to go from a private company to a public company, the owners of that company engage in an underwriting process whereby negotiations determine a specified sale of stock of the company to an investment bank. That investment bank serves as the underwriter for the IPO offering. These big banks – although few – then proceed to sell their shareholdings to the public.

Of course, the underwriters are the ones who are assuming all the risk upfront. In order to generate profitable returns, they must sell their stock which they purchased from the private company for a greater figure. Underwriting is an extremely important component oz the IPO process. It is these investment banks that allow private companies to list on public markets. In the run-up to an IPO listing, stock prices routinely rise well above the anticipated IPO price.

News of an IPO generates lots of buzz in the financial markets. You are likely to hear about exciting new listings on the ASX, the TSE, the Dow Jones Industrial Average, the NASDAQ, or the New York Stock Exchange. Many retail investors and institutional investors eagerly anticipate IPO listings. Underwriters get lots of juice out of their IPO listings as pricing often goes through the roof in the hours after a new stock has launched.

Unfortunately, many IPOs witness tremendous whipsaw price activity after listing. An initial burst of buying is oftentimes followed by massive selling, as profit takers ‘pump and dump’ their shares. This leads to extreme volatility, making IPOs a highly risky investment proposition for novices.

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Getting Ready for an IPO

There is some debate about the viability of the financial portfolios that are comprised exclusively of IPO holdings – some investors believe that this is the best way to go, given the outsized returns, but there is also significant downside risk. Nobody can anticipate the future performance of a company. The valuation of a company depends on the accurate forecasting of the financial data.

Provided a company has the right management and leadership at the helm; these people can make the difference between success and failure. Companies must always be audit-ready before pulling the trigger for an IPO. A careful and methodological analysis of the company's tactical and strategic goals must be carried out to determine the best business practices for long-term growth.

Many companies are foregoing the IPO option and simply using venture capital funding to grow operations and retain the control of their companies. On average, it takes between 6 and 9 months for the Securities Exchange Commission (SEC) to approve an IPO. Costs in the region of $13 million abound. Plus, it also takes money to remain a public company. There are many examples of IPO success stories and many more examples of IPO catastrophes.

There is no crystal ball to determine which way a business will go, suffice it to say caution is the order of the day.

Why are IPOs Inherently Risky?

For starters, IPOs are unproven companies. They have just listed as public companies, so they don't have a track record of performance at this level of operations. Unlike established enterprises with years of public company experience, shareholder reports, balance sheets, income statements, cash flow statements, analysts’ opinions, and general sentiment from a mass-market of investors, IPOs are the greenhorns of the stock market.

Lacking in historical performance and data, there are plenty of unknown variables at play, as such, investing in IPOs is a risky exercise. Fortunately, savvy investors can easily uncover important information about the finances of these newly formed public companies. That information is available in public filings in the form of financial records.

As an investor, it behoves you to conduct due diligence into the performance of companies listing on public markets, provided you play your proverbial cards right, it is possible to pick an up-and-coming star in the IPO realm and to mint it like a boss.

The issuing company, let's say XYZ, is ably assisted by investment banks throughout the process. The primary issuance of shares from the investment banks to the public is then bolstered by a large and robust secondary market of trading activity where shares are bought and sold en masse.

Interesting to Know

IPOs indicate that a private company has decided to go public. IPOs are often surrounded by lots of hype and hysteria. Companies that can whip up lots of interest with the mass-market typically burst onto the scene; but if their performance fails to live up to expectations, the company could go out of business within a few years. There are many such cases of IPOs going belly up in the 1990s and 2000s with the dotcom boom.

As a rule, it is incumbent upon you to study the ‘preliminary prospectus’ of the issuing company's performance. This is also termed a red herring. Invaluable information is provided with this prospectus, notably the number of shares to be issued, expected pricing of those shares, share ownership holdings, and more importantly the potential downside risks of purchasing shares in the company.

When you decide to get involved in an IPO, you agree to purchase shares at the price before trading activity takes place in the secondary market. Various criteria need to be fulfilled, notably eligibility requirements. Believe it or not, sometimes IPOs are only available to investors with high net worth.

Many brokerage firms will limit their clients’ access to IPOs based on the number of assets that those clients have at those brokerage firms. So, as you can tell, it's not all easy pickings when investing in IPOs. Most of the time, the demand for the shares of an IPO exceeds the supply, making these a hot item in the financial markets.

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Be advised that you may not be allowed to sell shares that you purchased in an IPO whenever you want. There may be what is known as a lock-up period in play which is designed to protect the value of the stock for a certain period. After you have purchased shares, anything can happen to the stock price and by the time the lock-up period is over, you could find yourself in some hot water.

The Inner-Mechanics of Returns, IPO Pricing, and Viability

For starters, the historical returns of IPOs indicate tremendous volatility. Dating back to 2007, IPOs on average had a -20% performance over 1 year. In 2008, that figure dropped to -28%. In the following three years, the 1-year performance of IPOs was positive, albeit at diminishing rates of return for each of the years 2009 (15%), 2010 (6%), and 2011 (1%). In 2012, IPOs generated outsized performance compared to the S&P 500 index with 57% returns, followed by 32% in 2013, 28% in 2014, and -9% in 2015. In 2016, IPOs generated returns of 46%.

As you can tell, IPO returns are extremely volatile and subject to a host of macroeconomic variables which determine performance. In respect to pricing, a complicated set of rules and procedures determines the precise price point for a private company to go public. The price point which balances the supply and the demand is typically considered as the equilibrium price for market participants. Assuming company XYZ decides to go public, they can offer several million shares for sale on the public market.

The current shareholders of the company (the private owners) will have their shareholdings of the company decreased according to ratios determined by the number of shares available to the public. Since private company shareholders/owners know exactly how much money they want to raise through the IPO and how much of the ownership willing to relinquish. Here’s a formula to help you understand IPO pricing and ownership:

  • Company XYZ has (N) number of shares
  • Company XYZ offers new shares to market (M) at price (P)
  • Existing ownership is diluted [(N/(N+M))]
  • Price is determined by what public will pay to own 1/(N+M)

Now, it’s time for an example:

If company XYZ has sold 25,000 shares for its IPO at AU$500,000, the AU$500,000 is divided up among 25,000 shares. The share book value in this case is AU$20 per share. It is always advisable to wait for the market hysteria to abate before evaluating the viability of investing in the new stock. For many investors however, the thrill of an IPO is too hard to resist. It's that initial run up in price that makes IPOs worth it.

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