An IPO, or Initial Public Offering, is the initial public offering of a company. It means that a company offers its shares for sale through the stock market for the first time, with which it hopes to attract fresh capital.
Private and public
In private corporations, a select few stockholders often possess the majority of the stock. Small businesses are typically privately held, and the founders and their families frequently own the shares. Large private enterprises do exist though. IKEA, Mars, and Domino’s Pizza are all privately owned businesses, in case you didn’t know. It is challenging to invest in these companies because their shares are not publicly listed.
On the other hand, we have the public companies whose shares are traded in the stock market in whole or in part. Private companies that do an IPO become public companies and gain many new shareholders in one fell swoop. They also have to comply with strict rules. For example, there must always be a “board of directors” and they are required to disclose their financial results every quarter. In the United States, publicly traded companies are required to report these things to the Securities and Exchange Commission (SEC).
What is the IPO process?
Companies that do initial public offerings (IPOs) are frequently still developing, have smaller market capitalizations, and are looking to raise money by selling shares in order to support potential future expansion. This is not always the case, of course.
Not all companies that conduct IPOs are small. Some can be huge, as was the case with Chinese e-commerce giant Alibaba.
Before an IPO, a company is considered private. Being private, the company’s business grows with a relatively small number of shareholders, including:
- Investors close to the founders
- Professional venture capitalists
A company will be interested in an IPO once it has reached the point where it is deemed mature enough to satisfy the requirements of exchange and assume the benefits and responsibilities to public shareholders.
The process of organizing an IPO consists mainly of two phases.
- The first is the pre-marketing phase of the offering.
- The second phase involves the IPO itself.
Before a company goes public, management must select the exchange on which it wants its shares to be listed and an underwriter (intermediary) to arrange the IPO. The company’s management may opt for more than one underwriter to jointly organize the planned IPO and manage different parts of the offering process.
These companies are involved in every part of the IPO process: due diligence, document preparation and filing, marketing, investor search, and share issuance.
In brief, the main steps of the IPO process are as follows:
- Underwriters submit proposals and valuations indicating their services, the best type of securities to issue, the offering price, the number of shares, and the estimated time frame for marketing.
- The company chooses its desired intermediary or intermediaries to arrange the offering and the exchange on which it wants to go public.
- It gathers the necessary information for the documentation required for the IPO process.
- Creating marketing materials for the launch of new issues and contacting potential investors.
- Formation of a board of directors.
- Ensure reporting processes – public finance and accounting information on a quarterly basis.
- The company issues its shares on the selected IPO date.
- Certain provisions may be adopted after the company goes public.
Once it has successfully completed these and certain other steps, the company is likely to become a public company and its shares will be available to a wide range of investors.
It’s very simple, with just a few clicks you can become a shareholder in a public company. Anyone with money can thus invest in a company that is traded on the stock exchange.
Why choose an IPO?
The main reason is to raise a lot of money in a relatively cheap and quick way. This money can then be used to finance acquisitions, expansions, or to pay off debts.
There are also a number of other financial advantages to a stock market listing. Public companies are more under a magnifying glass than private companies. Public companies are aware of this and know that they have to pursue sensible policies because they can easily be punished by the market. With the market as a watchdog, a company is more likely to get a more attractive interest rate when taking out loans. Another advantage is that they can easily finance mergers and acquisitions by issuing additional shares. Trading shares on the stock market provides additional liquidity, making it easier to pay out any performance bonuses to employees in the form of shares.
In the past, it was not easy to conduct an IPO. Only reputable companies with strong fundamentals and good prospects were eligible. With the advent of the Internet, it has all become much easier. Even smaller startups can already conduct an IPO to raise capital for expansion.
Still, investors should always remain cautious about participating in an IPO. After all, there are companies that go public without ever having made a dollar profit. To get investors excited about the stock, huge sales growth figures are presented with rosy future scenarios. But a high turnover does not mean a profit. In the end, every company is about how much profit remains at the end of the ride. In an IPO, the founders may have the intention to cash in quickly and see the IPO more as their own exit strategy.
The First IPO
Dutch East India, often known as VOC for its Dutch name Vereenigde Oost-Indische Compagnie, is the subject of the first Initial Public Offering (IPO).
The King granted the company a monopoly on trade with the East Indies and sovereign rights over all newly discovered lands when he formed it in 1602. The world’s first IPO happened on the Amsterdam Stock Exchange, which was founded the same year and is the oldest continuously operating stock exchange in existence.
The largest IPO
Alibaba Group Holding Limited had the largest first public offering to date. On September 18, 2014, the Chinese diversified e-commerce company went public and raised an astounding $21.8 billion.
A further option to sell shares would be exercised four days later, valuing Alibaba’s much-anticipated IPO at $25 billion.
On the first full day of trading on the NYSE, Alibaba shares began trading at $92.70. You can see a chart of the price of Alibaba’s stock in the graphic below:
An IPO is nothing more than selling shares. It has everything to do with the proper marketing of the stock. If they manage to convince enough people to buy the stock, they can make ridiculous amounts of money in a short period of time. An IPO generally involves one or more banks as issue companion banks.
For serious investors, it is wiser to avoid IPO stocks. By definition, IPOs are surrounded by euphoria and optimism. Warren Buffett has never bought shares in an IPO in his entire career. He says the following about this:
It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).
An IPO is also a very lucrative business for the accompanying banks. They receive a commission on the value of the shares sold. The higher the price the more they earn. Accompanying investment banks will therefore do everything they can to make an IPO successful and convince investors to buy shares. They try to squeeze every penny out of an IPO. This is characteristic of IPOs. IPO shares are therefore by definition high priced and contain no margin of safety. This makes the chance of a nice return a whole lot smaller.