An initial public offering (popularly known as IPO) can be described as the birth of a company in its public form. It usually changes several things about the manner by which the management operates the firm. It has the potential of presenting dangers and opportunities for retail investors. An IPO is one among the three ways by which a private company can arise capital that exceeds its ability to self-finance via operating cash flow. The other two ways are private investment and debt.
In stock market IPOs, the owners of a private company sell part of their company to public investors and it is normally done via an underwriting process that resembles and operates like a pyramid.
The IPO Process
Step 1: The Decision
A company that is privately owned makes the decision to seek external investors to raise money. This is usually the very first step.
Step 2: Notify the Government
After making the decision to seek outside investors, the company submits a disclosure
document that is very detailed that explains its risk factors, strategies, financial results and even its business to the Securities and Exchange Commission (SEC) experts.
Step 3: Generating interest
This 3rd step involves companies going on an investor roadshow whereby the management shares with institutional investors a presentation about the company. Similarly, the presentation is made available online. The company carries out negotiations for sale of its stock to an investor bank or more that serve as underwriters for the offering.
Step 4: Setting the price
The night just prior to the exchange listing, the stock’s price is set depending on the investor interest. The company receives money and the investors receive shares in exchange. The shares the investors receive are a portion that will be sold the next morning on the stock market.
Step 5: Selling Stock
Each of the few underwriters then sell the stock they have to the significantly larger pool of invest present in the public markets.
Underwriters receive compensation through fees as well as underpricing in the stock that they are purchasing from the company. Every underwriter takes the risk that she/he will be able to sell the stock that was sold to him or her by the company for more money than they paid, a stock that was underpriced.
Underwriters provide the company with value through making large purchases as well as facilitating an orderly sale of the initial stock their former stock.
Retail investors and other institutional investors can buy the stock in the public market. However, it is uncommon for an IPO that is anticipated to result in a fast run-up in the price of the stock.
The above insightful information is just a summary of the IPO process in the stock market. This is because the actual procedures are quite complicated. It should be noted that the process outlined above is the most common technique for IPOs, as other formats exist. Hybrid auctions or an auction format is rare but can be used in an attempt to make the process a bit more equitable.