What is an “Initial Public Offering”?
When a private corporation offers shares on a public stock exchange for the first time, it is referred to as an initial public offering (IPO). IPOs are a useful way for companies to raise capital from new investors, through the issuance of public share ownership. Post IPO, the shares are traded in the secondary markets.
Companies enter into an IPO transaction with certain objectives, including generating capital needed to expand organically or via acquisitions, raising public awareness of the company, reducing leverage or as an exit strategy of the original founders. As such, the transition from a private to a public company can be a crucial time for private investors to realize gains from their earlier investment.
Key Learning Points
- IPOs offer companies the opportunity to obtain capital by offering shares through the public primary market, meaning previously owned private shares convert into public ownership
- After the IPO, the public shares are traded freely in the open secondary market
- Stock available on the secondary market is known as the free float
- Companies must meet the listing requirements of local regulators and stock exchanges such as minimum size, minimum free float and appropriate corporate governance
- IPOs are typically managed and sometimes underwritten by one or more investment bank, who arrange for the shares to be listed on one or more stock exchange
- The number of shares the company sells and the price of those shares ultimately determine the company’s equity value, i.e. the Public Market Capitalization (market cap)
The IPO & Underwriting Process
When a company reaches a stage mature enough for the rigors of regulators it can consider starting an IPO process. Companies have to reach certain requirements including: minimum size and free float requirements, along with being able to offer the benefits and responsibilities to public shareholders such as rigorous corporate governance. In addition, most stock exchanges have a minimum free float requirement of at least 20% of the company’s shares.
It is possible for smaller and less mature companies to pursue an IPO, particularly companies with strong fundamentals and proven profitability depending on their ability to meet local listing requirements. It should be noted that IPO regulation differs on a country by country basis, as every exchange and every regulator have their own specific listing requirements.
A full IPO process consists of two parts. The first is the pre-marketing phase which includes due diligence, the initial valuation as well as market checks for demand and price, often described as ‘soft circling’. The second phase involves management presentations and investor meetings closely followed by the actual ‘going to market’. A company may choose one or several underwriters to manage the different aspects of the IPO process: IPO due diligence, document preparation, filing, marketing, valuation and pricing, issuance and stabilization. During the IPO process the company can also decide to follow an alternative IPO process, such as a direct listing or a Dutch IPO.
A direct listing is an IPO process which completely skips the entire underwriting process. The issuer is prepared to face higher execution risk in return of reduced transaction fees and execution complexity. In a Dutch auction, the IPO price is not set. Potential buyers can bid for as many shares as they want at a particular price point. The shares are then allocated to the highest bidders. During the IPO process the pre-IPO shareholders can decide if they want to preserve control by selling less than 50% of their shares into the public market; a so-called minority IPO. Selling more than 50% of the existing shares is commonly considered a majority IPO. A full exit is achieved if existing shareholders offer all of their shares.
Example: Pre-IPO and Post-IPO Balance Sheet
Given below are some key statistics of a company about to be IPO’d. The assumption is that the company is currently owned by Blackstone and planning to IPO this year.
You can see that Blackstone’s main IPO objective is to repay expensive debt. The company is planning to sell 28 million shares with an offer price of $18. From those IPO proceeds, fees of 2.5% ($17.6 million) will have to be paid. Based on the company’s desire to repay $544 million of TLB and Second Lien from the proceeds of the IPO, you can try to calculate the Sources and Uses and reconcile the post-IPO Balance as shown below.
IPOs can provide companies with an opportunity to obtain capital by offering shares through the primary market. The transaction typically includes a share premium for current private investors and can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment.
If there is sufficient demand, the public market opens up opportunities for millions of investors to buy shares in the company and contribute to the shareholders’ equity. Hence, the largest advantage of an IPO is the creation of a public valuation for the company, known as the Market Cap.