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Financial Literacy

The IPO Process: A Step-by-Step Guide to Going Public

Last year, investors speculated many companies would announce an IPO (initial public offering). But investors are still waiting for most of them to hit the market. That’s because the IPO process can take many months or even years to complete.

There are a few reasons a company decides to launch an IPO. The top reason is to raise capital. And in some cases, early investors want to cash out. Another benefit to going public is to increase brand visibility. Whatever the reason, going public can be a grueling and time-consuming process.

Below is a step-by-step guide to the IPO process. Let’s get started…

The IPO process can set companies up for success

What is the IPO Process? Explained in 7 Steps

Step 1: Choose an IPO Underwriter

The first step of the IPO process requires the company to select an investment bank. These banks are registered with the SEC (Securities and Exchange Commission) and act as underwriters. IPO underwriters are specialists who work alongside the company issuing the IPO. They help determine the initial offer price, buy the shares from the issuing company and then sell the shares to investors. Usually, they have a network of potential investors to reach out to in order to sell the shares. There a few things to consider when choosing an underwriter:

  1. Reputation
  2. Quality of research
  3. Industry expertise
  4. Network distribution reach
  5. The company’s prior relationship with the investment bank
  6. The underwriter’s past relations with other companies.

Underwriting an IPO can be a long and expensive process. It requires time, money and a team of experts. But a good underwriter can be the difference between a successful IPO and an IPO failure.

Step 2: Due Diligence

Due diligence is the most time-consuming part of the IPO process. In this step, there’s a pile of paperwork the company and underwriters fill out. The issuing company needs to register with the SEC. Then, there are contracts between the company and the underwriter.

Firm Commitment. This agreement states the underwriter will purchase all shares from the issuing company. They will resell them to the public.

Best Efforts Agreement. The underwriter does not guarantee an amount of money but will sell the shares on behalf of the issuing company.

Syndicate of Underwriters. Sometimes IPOs come with large risk, and the bank doesn’t want all of it. In this case, a group of banks will come together under the leading bank to form an alliance. This alliance allows each bank to sell part of the IPO, diversifying the risk.

Engagement Letter. There are usually two parts of an engagement letter:

  1. The reimbursement clause states the issuing company will cover the underwriter’s out-of-pocket expenses.
  2. The gross spread, also known as the underwriting discount, is typically used to pay the underwriter’s fee and/or expenses. It can be found by taking the price the underwriter paid for the shares and subtracting it from the price they sell them for. Think of it as wholesale. Because the underwriter is buying all of the shares, they receive a discounted price.

For example, there are 1,000 shares each priced at $10. The underwriter purchases them for $8 per share, spending $8,000. Then, the underwriter sells the shares on the market at their $10 value, making $10,000. That’s a gross spread of $2,000.

Letter of Intent. There are three parts to a letter of intent:

  1. Underwriter’s commitment to the company
  2. Company’s agreement to provide all information and cooperate
  3. Company’s agreement to offer underwriter a 15% overallotment option.

Red Herring Document. This is a preliminary prospectus that includes information about the company’s operations and prospects except for key issue details, such as price and number of shares.

Underwriting Agreement. Once the price of shares is determined, the underwriter is legally bound to purchase the shares at the agreed-upon price.

S-1 Registration Statement. This is required to be submitted to the SEC. There are two parts:

  1. Information Required in Prospectus — The prospectus is a legal document provided to everyone who is offered and/or buys the stock. It must clearly describe the company’s business operations, financial state, operations results, risk factors and management. Audited financial statements must also be included.
  2. Information Not Required in Prospectus – Includes additional information and exhibits that the company is not required to deliver to investors but must file with the SEC.

Step 3: The IPO Roadshow

An IPO roadshow is a traveling sales pitch. The underwriter and issuing company travel to various locations to present their IPO. They market the shares to investors to see what demand, if any, there is. Looking at investor interest, the underwriter can better estimate the number of shares to offer.

Step 4: IPO Price

Once approved by the SEC, the underwriter and company can decide the effective date, number of shares and the initial offer price. Typically, the price is determined by the value of the company. This is done by the valuation process and occurs before the IPO process even begins.

There are a couple factors to consider when pricing an IPO:

  • Value of issuing company
  • Reputation of issuing company
  • Success/failure of the IPO roadshow
  • The issuing company’s goals (i.e., amount of money to raise)
  • The condition of the economy.

It’s common for an IPO to be underpriced. When underpriced, investors will expect the price to rise, increasing demand. It also reduces the risk investors take by investing in an IPO, which could potentially fail.

Step 5: Going Public

Now that everything is decided, it’s time for the IPO to go live! On the agreed-upon date, the underwriter will release the initial shares to the market.

Step 6: IPO Stabilization

There is a short window of opportunity where the underwriter can influence the share price. During the 25-day “quiet period,” which occurs immediately after the IPO, there are no rules preventing price manipulation. The underwriter ensures there’s a market and buyers to maintain an ideal share price. There are a couple of strategies used by underwriters:

Greenshoe Option

In the letter of intent, there is a clause that allows an overallotment option. Also known as the greenshoe option, this allows underwriters to sell more shares than originally planned. Then the underwriter buys them back at the original IPO price.

If the share price decreases, the underwriter buys back the over-allotted shares. The underwriter will make a profit because the price is less than what they originally sold it for.

If the share price increases, the underwriter has the option to buy the shares at the original IPO price, avoiding loss. This is stated in the contract with the company under the overallotment clause.

Overallotment is a popular choice because it’s both SEC-permitted and risk-free. While overallotment is the legal term, it’s commonly referred to as the greenshoe option because Green Shoe Manufacturing (now Stride Rite) was the first company to do it.

Lock-Up Period

At the beginning of this article, it was mentioned that when a company goes public, anyone who already owned shares could cash out. However, those shares can only be sold following a lock-up period.

A lock-up period is a predetermined amount of time, usually lasting between 90 and 180 days, when insiders who owned shares before the company went public are not allowed to sell their stock. This avoids flooding the market with the company’s shares and driving the price down.

Step 7: Transition to Market Competition

This is the final stage of the IPO process. After the 25-day quiet period, the underwriter and investors transition from relying on the prospectus to looking at the market.

Everything is now public and out of the underwriter’s hands. The underwriter can provide the company with estimates on the company’s earnings and post-IPO valuation. The underwriter also moves into the role of advisor as the shares fluctuate in the public market.

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Amber Deter has researched and written about initial public offerings (IPOs) over the last few years. After starting her college career studying accounting and business, Amber decided to focus on her love of writing. Now she’s able to bring that experience to Investment U readers by providing in-depth research on IPO and investing opportunities.

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