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What Is IPO in Business and How Does It Work?

Mar 8, 2024 | Business and Leadership Skills

What is IPO in business? An Initial Public Offering, or IPO, is a transformative process that catapults a private corporation into the public domain, allowing it to sell shares to the broader public. This strategic financial move provides a significant capital boost and marks a milestone in a company’s growth trajectory, expanding its investor base beyond the initial circle of founders, private investors, and venture capitalists.

The journey from being private to going public is intricate and multifaceted, involving meticulous planning, regulatory compliance, and a series of steps to ensure a successful transition. As companies navigate this path, they encounter both opportunities and challenges, from gaining increased market visibility to dealing with the added pressures of public scrutiny and reporting obligations.

Introduction to IPOs

Definition of an IPO

An IPO is a pivotal event in a company’s lifecycle where it offers shares to the public for the first time. This transition from a private entity, typically with a limited shareholder base of founders, family, friends, and early investors such as venture capitalists, to a public one marks a significant shift in a company’s capital structure and stakeholder composition. The process enables a company to raise equity capital from a broad spectrum of public investors, increasing its shareholders’ equity and liquidity.

Why Companies Go Public

A company might decide to go public for several strategic, financial, and operational reasons. An IPO is seen as a way to raise substantial capital. This new funding can be used for expansion plans, research and development, marketing initiatives, and capital expenditures.

It also offers an opportunity for the company’s early investors to cash in on their investment, often at a premium, as the shares transition to being valued at public market prices.

Going public can boost a company’s visibility, prestige, and credibility, which can positively affect its sales and profitability. The increased transparency required of public companies often results in more favourable credit terms from lenders compared to private companies. Plus, being listed on a stock exchange increases the liquidity of a company’s shares, making it easier for shareholders to buy and sell their stakes.

But the journey to becoming a public entity has its challenges. The costs associated with an IPO can be substantial, and the ongoing expenses of maintaining a public company status, such as regulatory compliance and reporting, add to the financial burden. The company’s management might find the focus on share price performance distracting, and the need to disclose sensitive business information could help competitors.

Moreover, the rigidity of corporate governance structures and the scrutiny of a public company can impact the company’s agility and risk-taking capabilities.

Despite these potential drawbacks, for many companies, the advantages of accessing a wider pool of capital, the ability to use shares as currency for acquisitions, and the prestige associated with being a publicly traded entity outweigh the disadvantages. The IPO process involves:

  • Careful planning.
  • Underwriting by investment banks.
  • Meeting regulatory requirements.
  • Marketing the share offering to gauge demand and set the price.

Once the company goes public, it must adhere to the stringent reporting and governance standards set by regulatory bodies and the exchanges on which its shares are listed.

The IPO Process

Selecting Underwriters

The first step in an IPO is choosing underwriters, which are usually investment banks that shepherd the company through the process and underwrite the shares. The selection is influenced by factors including the banks’ expertise in the industry, their standing in the market, the quality of their research, and their ability to distribute the shares. Companies may work with a single underwriter or assemble a syndicate, with one acting as the bookrunner and others as co-managers to aid in distribution.

Underwriters perform tasks such as evaluating risks, determining the share price, and ensuring the shares are sold. They may enter into various agreements with the company, defining the level of risk they are prepared to assume. The underwriting process also involves creating key documents like the Engagement Letter, Letter of Intent, and Underwriting Agreement, which set forth the terms of their services and commitment.

Filing the Registration Statement

The next step is to submit a registration statement to the SEC. This document includes detailed information about the company’s financial status, management, insider holdings, legal matters, and the intended ticker symbol. The SEC reviews the registration statement to verify that all necessary information is disclosed correctly.

During this stage, the company might also submit private filings to the SEC, which take time to be public. The Prospectus, included in the registration statement, is a document that will be distributed to every investor buying the securities. In the so-called cooling-off period, the underwriters prepare an initial prospectus, known as the Red Herring Document, which lacks the final date and offer price.

The IPO Roadshow

The Roadshow is where the company and underwriters pitch the investment opportunity to potential investors through a series of presentations. These can be held in various locations or conducted virtually. The Roadshow is an opportunity for the company to highlight its strengths, business strategy, and future growth potential to stimulate interest and assess investor demand.

The duration of the Roadshow varies, and it is during this time that underwriters conduct the book-building process, gathering bids from investors to inform the initial offering price.

Pricing the Shares

The final step before the IPO is launched is determining the offer price, which is set the evening before the IPO begins. This price is crucial as it affects the amount of capital raised and the company’s public market valuation. The offer price is influenced by the roadshow results, current market conditions, and the company’s goals. To ensure full or even excess subscription, IPOs are typically underpriced, compensating investors for the risk they take on.

After the shares are priced and the IPO commences, underwriters may buy shares to mitigate order imbalances and stabilise the stock market. This after-market stabilisation helps protect against price fluctuations in the initial days after the IPO. Following a 25-day quiet period, the company enters regular market competition, and the success of the IPO can be assessed through indicators such as market capitalisation and stock performance.

The IPO process is essential for a strong financial market. It allows private companies to tap into public capital and offers investors a chance to share in their growth. It is a structured path that necessitates detailed planning, adherence to regulations, and strategic marketing for a successful outcome.

Businessman Pointing To IPO In Diagram

Advantages of Going Public

Access to Capital

An IPO enables a company to generate significant funds by offering shares to the public, which can be utilised for various business needs.

Increased Public Awareness

The transition to a public entity often results in heightened media attention and brand exposure, which can attract new customers and beneficial partnerships.

Liquidity for Shareholders

Publicly traded shares provide shareholders, including founders and early backers, with the option to sell their stakes more readily, enhancing the attractiveness of the company’s stock as a form of compensation.

Valuing the Company

Public companies may achieve a higher market capitalisation, reflecting the investment community’s valuation, which is advantageous for mergers and acquisitions. The transparent valuation process required of public entities allows for a more precise assessment of their worth. The company’s projected growth, industry benchmarks, and investor interest influence the pricing of shares during an IPO.

Businessman Pointing to Word IPO

Risks and Considerations

Market Volatility

Equity markets are subject to fluctuations that can affect the timing and outcome of an IPO. These variations may be due to a range of factors, including global political unrest, economic shifts, and industry-specific challenges. In periods of high volatility, it can be not easy to establish a stable valuation, potentially leading to a reduction in IPO activities.

Despite such challenges, certain industries may proceed with their public offerings, motivated by positive economic indicators. Companies must remain flexible and responsive to the dynamic nature of the markets to ensure a successful transition.

Legal and Regulatory Compliance

Transitioning to a public company entails stringent adherence to legal and regulatory frameworks. The SEC plays a pivotal role in monitoring public companies, mandating comprehensive disclosure of financial and operational details. This increased level of disclosure can expose companies to new legal risks.

The management team must now prioritise consistent profitability and manage a broader array of stakeholder expectations, which can add to the complexity of corporate operations.

Costs of Going Public

The financial outlay for an IPO includes direct costs such as underwriting fees, legal and accounting services, listing charges and significant indirect expenses. These may encompass infrastructure investments to support a public company operational needs company’s operational needs. Additionally, ongoing expenses for regulatory compliance, including audit fees and adherence to regulations like the Sarbanes-Oxley Act, are critical for long-term financial strategy. These costs can be substantial and vary based on the company’s preparedness and existing systems.

This financial aspect is a crucial factor for company leadership to consider.

Potential Loss of Control

Companies considering an IPO are concerned about losing decision-making autonomy. Issuing different classes of stock with varied voting rights is one method of retaining control by ensuring that founders and principal stakeholders hold shares with greater voting power.

This tactic can also serve as a defence against hostile takeovers but may only be favourably viewed by some investors, particularly if they perceive their influence as being diluted. Companies with a dominant shareholder or group may be exempt from certain exchange mandates, such as maintaining an independent board, which can affect perceptions of accountability and, consequently, the company’s market performance. Striking the right balance between maintaining control and appealing to investors who expect equitable treatment and governance influence is essential.

Man Looking At IPO On Phone

IPO Alternatives

When a company decides to raise capital by entering the public market, an IPO is often seen as the go-to method. However, there are alternatives that companies might consider, each with its own benefits and things to think about.

Direct Listings

Direct listings, or Direct Public Offerings (DPOs), offer a more cost-effective path for some companies. In a direct listing, a company sells shares directly to the public without the help of underwriters. This approach eliminates the need to create new shares, which can prevent dilution of existing ownership.

It also skips the underwriting fees. A significant advantage of direct listings is the absence of lockup periods, allowing immediate liquidity for current shareholders. Companies like Spotify have successfully gone this route. As of December 22, 2020, the SEC has even greenlit companies to raise capital through direct listings, giving this method more credibility.

SPACs (Special Purpose Acquisition Companies)

SPACs have become a popular alternative for private companies to go public. An SPAC exists solely to merge with a private company, taking it public in the process. This can lead to higher valuations and quicker access to capital than traditional IPOs can offer.

SPACs can also bring more certainty and transparency with lower fees and less red tape. However, some SPACs need help finding the right match and can flop, which might mean investors lose out. Nevertheless, the SPAC route is tempting for many businesses looking to make their mark on the public markets.

Private Placements

Private placements are when securities are sold to a select group of investors and institutions instead of the general public. This route is less regulated than public offerings, letting companies raise funds while putting off or even skipping an IPO. Governed by the SEC under Regulation D, private placements require a private placement memorandum (PPM) to sell securities.

They can’t be widely advertised to the public. Startups often favour private placements because they get the capital they need for growth without the pressures and scrutiny of being a public company. This way, companies can keep control over who invests and have more freedom to negotiate terms than they would on the public market.

Employee Stock Ownership Plans (ESOPs)

ESOPs are a unique way for companies to build a sense of ownership among their employees. ESOPs are employee benefit plans that give company shares to workers, aligning their interests with those of the shareholders. These plans can act as a corporate finance strategy and come with tax advantages for the sponsoring company, the selling shareholder, and the participants.

ESOPs are set up as trust funds and can be funded in different ways, such as the company contributing new shares, cash to buy existing shares, or borrowing money to purchase shares. ESOPs motivate employees by making them stakeholders and help boost productivity and growth.

Companies of various sizes, including large publicly traded ones, use ESOPs. They must operate fairly and have a trustee who acts in the best interest of the plan participants.

Navigating the IPO Waters

Choosing the IPO route is a significant strategic manoeuvre that offers lucrative benefits and opens up new challenges. It’s a pathway lined with potential for growth, increased recognition, and financial prosperity, but requires a deliberate tread. Companies must weigh the immediate allure of public capital against the enduring commitments of public scrutiny and compliance.

As markets evolve and new alternatives emerge, the landscape for public offerings remains dynamic. Each company’s journey is unique and demands a tailored approach that aligns with its long-term objectives and values. Whether through a traditional IPO, a direct listing, a SPAC, or another method, the decision to go public is a testament to a company’s ambition and its readiness to embrace the future.

For those prepared to navigate the intricate waters of an IPO, the voyage can lead to realms of opportunity and success.

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