Jonathan Lepre and Adam Wood, Harvard University
Published by Aaron Gose
An IPO is summarized as the first time the stock of a private company is offered to the public. The term “public” implies the general investment community, but at first mostly to institutional investors such as a hedge fund. The Institutional investors are the clients of the underwriting firm, typically an investment bank such as J.P. Morgan or Morgan Stanley with prestige and accessibility to raising large amounts of institutional capital.
The underwriter not only helps raise awareness and capital for the IPO, but the bank also assists the issuer in determining which type of security to issue, along with the number of shares in accordance with the best offering price and timing to bring the company to market. The issuer’s major selling point is the company’s prospectus report, which is circulated to potential investors containing relevant information of background overview, future expectations in financial performance, and price outlook.
Before the due diligence process can begin, the deal construction process is underway. For larger offerings where there is an expectation for a sizeable amount of investor interest, investment banks may choose to form what is called a syndicate of underwriters, when multiple investment banks have their banking teams work together. The selected firm may also choose this method for a riskier offering if they wish to spread the risk around the street.
The other two types of agreements that are constructed between the underwriter and issuer are called best efforts and firm commitment. A firm commitment is a guarantee to the issuer that the underwriter will sell a certain amount of shares to the public by purchasing the offer itself, and conversely, a best efforts agreement is formed when the underwriter does not guarantee the amount raised.
Main Initiatives for Going Public
Companies may elect for an IPO for a variety of reasons, but the list below are some of the primary justifications.
The first reason may be the company is looking to market themselves. As a seemingly lesser-known company, there is no better way to put the brand in the center stage spotlight by going public in the eyes of attracting new investors and clientele.
More common reasons are to raise capital for expansionary opportunities such as acquiring companies via stock equity, or a quicker strategy in paying back debt burdens.
If the firm is private equity or venture capital-backed before the Initial Public Offering, they can also be looking to provide an exit strategy through the IPO transaction.
Historical IPO Stock Price Trend
As graphed in the chart below, IPO’s tend to perform very well on the first day the company is brought to market, as the demand and typical hype is high, but the stock will usually under perform the wider market over time.
Investors interested in IPO’s are willing to accept a high probability of below-average returns for the opportunity in being a part in rolling the dice for a low probability in major returns of these companies that are seeking to be high growth percentages.
Secondary market selling after the initial offering also strongly effects prices. Since the prices are set by optimistic views as mentioned above, there can tend to be an initial overpricing which will effect long-term performance. Fundamentals will additionally later be closely assessed as for the most part much newer company’s going public have a shorter cash flow history.