Initial Public Offering (IPO)

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What is an Initial Public Offering (IPO)?

An Initial Public Offering (IPO) is a corporation's first sale of common shares to public investors. Typically, a company hires an underwriter (an investment bank or a syndicate of investment banks), to underwrite (handle) the offering and a legal firm to assist in drafting the prospectus.

The sale of stock is overseen by financial regulators and where relevant by a stock exchange. It is usually a requirement that disclosure of the financial situation and prospects of a company be made to prospective investors.

IPO Mechanisms. Methods of Issuing Shares

There are several methods of issuing stock, for example in an IPO:

• Underwriting
  • Bought Deal
    • An underwriting agreement in which the investment bank (or bank syndicate) commits to buy all shares to be issued from the client company (before a preliminary prospectus is filed) and then sells them to third party investors.
    • For the issuing company this means it can be sure that all shares are sold for the agreed price. Also it doesn't have to wait. However it is likely that the price is lower than what it might have received should it have taken the risk that the shares are not being sold.
    • For the underwriter this is a high-risk deal, since some of the shares may not be sold, be sold later, or be sold for a lower price. Also during the deal process, the underwriter uses up its capital, which could have been put to use otherwise also.
    • In this form the underwriter will be co-responsible (and co-liable) for the prospectus.
    • On the other hand, the underwriter typically receives a substantial fee ("discount" to the current market price, if applicable) for its services.
  • Firm Commitment Contract
    • Similar to bought deal, except that the underwriter just guarantees that the shares will be sold for some price, without being a party in between.
    • This means that the underwriter will have to buy shares itself if a number of issued shares are not bought by third party investors.
    • The amount of capital needed is lower than in a bought deal.
  • Best Efforts Contract ("Fully Marketed Offering")
    • An agreement in which the underwriter promises to (merely) make an attempt to sell as much of the shares as possible to third parties.
    • Typically, best effort agreements are used for issuing stock when there is perceived to be a higher risk for the underwriter, such as unseasoned offerings, or in unfavorable market conditions.
    • Such best effort agreements limit the underwriter's risk (because there is no guarantee given that it will sell the entire share issue).
    • On the other hand, best effort agreements also limit the potential profit the underwriter can make (because normally a flat fee is agreed).
• Dutch Auction
  • An unusual, alternate method of issuing shares, recently used in Google's IPO.
    
    

Reasons for Initial Public Offerings

For the founders IPO's are primarily an Exit Strategy and for participating Venture Capitalists a way to cash in on their investments as their shares are now given a market value.

To the previously private company, an IPO may offer the following benefits:

• Increasing and diversifying its equity base
• Enabling cheaper access to capital
• Increasing exposure, prestige, and public image
• Attracting and retaining better employees and executives (through long-term incentives (equity participation)
• Facilitating acquisitions (in cash or potentially in return for shares of stock)
• Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.

Disadvantages of an IPO

There are also a number of disadvantages to choosing for an initial public offering:

• Ongoing (annual) legal, accounting and marketing costs
• Requirement to disclose financial and business information which may be useful to competitors (see: competitive intelligence), suppliers and customers
• The time, effort and attention that senior executives have to spend on the above
• The risk that the required funding will not be raised (fully) after all
• Public dissemination of information

All following issuances of shares (after the initial public offering) are being called: secondary market offerings.

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