What is IPO and How Does it Work?

IPO or the initial public offering is the process of offering shares to public investors. Companies release IPOs to raise money from the public and that is why IPOs are generally discounted. This makes IPO an attractive deal for companies since they can gain numerous buyers from primary issuance. Investors usually refer to the prospectus for referring to information related to the IPO.

These may be retail or institutional investors. It is the fundamental step in the process of going public from a private business. This blog will help in building an understanding of what it is and how an initial public offering works.

Table of Contents

• Benefits
• How does it work?
• Process
• Factors affecting the performance

Companies offer IPO with the aim to go public and gain more investors. Releasing an Initial Public Offering requires a team of experts who work till the end of the stock becoming public.

Benefits of IPO

• Companies are privately owned before the release of IPO. 
• Once they release shares publically, they can raise capital from public investors. 
• It increases the company’s public presence and helps them with easier acquisition deals. 
• There is a positive spike in the company’s sales and profits after the release of the IPO. 
• Companies use IPO to raise new equity capital so that they can monetize the investments of private shareholders. 
• It eases the process of trading existing holdings. After the release of the IPO, shares can be freely traded in the open market.

How IPO Works?

The process of IPO works majorly in two stages. The first stage is the pre-marketing phase of the offering while the second stage is the initial public offering. When a company decides to release its IPO, it can do one of the two things. 

It can either issue a public statement announcing the release of IPO or it can solicit private bids by advertising it to underwriters. An underwriter is a professional that evaluates a party’s risk in lieu of a fee. The fee may include commission, interest or premium. A company may hire one or more underwriters. 

The underwriter leads the process. The professional is ensures due diligence, preparation of documents, filing, marketing of the IPO and its issuance. An IPO team consists of lawyers, certified public accountants (CPAs), underwriters and Securities and Exchange Commission (SEC) experts.

Process

Let us now understand the entire process in detail.

1. The underwriters will underwrite terms through an agreement.
2. Underwriters will present the proposal and valuation to discuss various aspects of the IPO. These will include the number of shares, their services, offering prices, estimated timeframe for market 
3. The team compiles company-related information as a part of the IPO documentation. The S-1 registration statement is the primary IPO filing document. It includes the prospectus and private filing information. It also contains information related to the expected date of filing. The team revises the S-1 document throughout the pre-IPO process. 
4. Underwriters and executives work on the marketing materials for the pre-marketing of new stock issuance. These professionals market share issuance for estimating the demand. According to that, they decide a final offering price. 
5. The entire process might undergo constant revisions throughout the marketing process. Revisions may occur to IPO prices, issuance date and financial analysis.
6. After the formation of a board of directors, the company will issue shares on the IPO date. 

The company receives capital in the form of cash from the primary issuance to shareholders. This is recorded as the stockholder’s equity on the balance sheet. The share value becomes reliant on the company’s stockholder’s equity per share valuation.

Investment in Initial Public Offering

Companies release IPOs to raise money from the public and that is why IPOs are generally discounted. This makes IPO an attractive deal for companies since they can gain numerous buyers from primary issuance. Investors usually refer to the prospectus for referring to information related to the IPO. 

This prospectus is available as soon as the company files the S-1 registration. Before investing in an IPO, investors should learn about the specifics of the deal. They should also consider the management and underwriters for the specific Initial Public Offering. 

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Factors Affecting The Performance of An IPO

There are a number of factors that are involved in the success or failure of an IPO. Let us see the factors that affect its performance:

1. Lockup Period

The lockup period is an important factor for assessing the performance of an IPO. Underwriters ensure that the company insiders sign a lock-up agreement. This prohibits insiders from selling shares of stock till a specific time period which may range between 3-24 months. 

After this lock-up period expires, there is no foundation on selling the stock. This leads to a surge in the selling of stock to realize profits. The excess supply of stock degrades the stock price. 

2. Flipping 

It is a practice of reselling the IPO within the first few days. Investors do so in order to realize quick profits. This usually happens when the stock is discounted.  

3. Tracking Stocks 

These are issued by the parent company and are presented as a special equity offering. These are useful in tracking the financial performance of the company stock. Investors can learn a lot about the parent companies through these spin-off stocks. 

Read more on the functions of financial management

IPOs are great for companies that want to gain short term gains and to attract investors. Since these are available at discounted prices, these may be great investment options. Before investing in IPOs, it is important to go through the prospectus and learn about the parent company of the IPO.