What are IPOs?

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20 June 2024

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What are IPOs?

Initial public offerings (IPOs) drive the financial world giddy: with “beauty contests” and rumours galore, they’re the closest we’ve got to a showbiz event. IPOs are where shares in a company are listed on a stock market for the first time, allowing the average investor (like you or me) to buy a piece of their favourite firms.

The actual process of selling shares on the stock market is often called “floating”, and it’s got a really long history – the first flotation was the Dutch East India Company in the early 1600s.

Why do companies float on the stock market?

As companies grow, they often need to raise funds to invest in things like opening a new factory or hiring extra people. They can either borrow money from a bank (raising debt) or sell a portion of the company’s ownership (known as its equity) to investors.

In the early days, companies can usually get by selling an equity stake to high-risk investors – venture capital funds or wealthy individuals called angels. Later, they might raise larger sums from the next tier of investors: private equity funds. At a certain point, however, a company simply becomes too big for these investors to handle and an IPO is the only option available.

IPOs are an exit strategy for the company’s early investors – those venture capital and private equity funds. It’s one of the only ways for investors to see a return, the other being if the company is sold to a rival. The same is true for founders and early employees, who may own shares in the company.

To top it all off, IPOs can be a great publicity driver, raising awareness of the brand among potential customers.

Are IPOs a good thing?

Actually, the number of public companies has been declining in the US, because more relaxed regulations have made it easier to stay private for longer and because some firms just don’t think it’s worth the hassle anymore. The IPO process is arduous and expensive, thanks to fees for bankers, lawyers, and accountants. It also makes life harder for the company.

Post-IPO, a company is considered “public” rather than “private”, and must by law be much more open about its finances. Preparing these financial statements takes time and can also give competitors more information about the company’s plans. It means the founders will lose more of their control over the company too, both through a reduced shareholding percentage and by having to answer to a legally-mandated board of directors.

Private capital is also way easier to come by these days. Companies can therefore put off the paperwork and remain private for longer.

Regardless, some do choose to IPO. Here, we’ll explain how the process works and what you need to know to get involved. Lie back and get ready to float…

How does an IPO process work?

An IPO is a long and convoluted process: here’s an overview.

1. The company chooses its partners

Once a company knows it wants to IPO, it has to start scouting out who it’ll work with. That involves choosing which stock exchange to list on. The exchanges get paid a listing fee, so put a lot of effort into wooing prospective IPOs: the UK, for example, went as far as changing laws in an effort to get oil giant Saudi Aramco to list in London!

The company will also choose an investment bank to act as an “underwriter” for the listing. This is an important job: the underwriter is effectively the shares’ salesman, drumming up interest from investors to buy the stock upon its listing. They charge their fees as a percentage of the sale proceeds – so, for the biggest listings, banks compete for the company’s business (in what’s sometimes called a beauty contest).

2. The company goes on a roadshow

The company executives and bankers will then pack their bags and go on tour – meeting with big investors and analysts to try and get them to buy shares or recommend them to their clients. They’ll show off the company in the best possible light, persuading investors that it’s an unmissable opportunity. This is also a way for the underwriters to gauge demand, so they can then set a price for the IPO.

3. The company publishes its prospectus

The formal prospectus contains all the company’s financial info and business plans, as well as a price range for the IPO. Analysts will pore over this info, trying to figure out if the company’s worth what’s being charged. After this is the offer period, where institutional investors (think wealth managers, hedge funds and investment banks) have the chance to request the first shares.

4. The shares list on the market

Eventually, the actual day of the listing will come around. The underwriters will allocate shares to those who expressed interest during the offer period and, when the markets open, trading can officially begin. Retail investors like you and me can then start buying the shares, and the institutional investors who got allocated stock in the IPO can start selling (though they’ll often agree not to for a while, to keep the share price high).

What is a “direct listing”?

Companies can go down the route of a “direct listing”. In this process, there are no underwriters or offer periods: the shares go straight onto the stock market. It can be risky however, because the company has no idea what will happen (the price is set by the market, rather than in advance by bankers) – but for a hot brand like Spotify, it can be a great way to save on underwriter fees.

How are company valuations set during an IPO?

Setting a company’s initial share price is ultimately the same as with valuing any other kind of financial asset: it’s about supply and demand. If loads of people want in on the share offering, that’ll drive the value up – and if the founders decide not to give too much away, the restricted supply could boost prices too.

That said, figuring out what price works for any given supply/demand level is really hard! There are a few techniques investors use to figure out what they’re willing to pay. They’ll look at the company’s business model and its opportunities for growth, and they’ll compare the stock’s valuation (versus key financial data like profit or revenue) against similar companies in similar industries. Investors also use previous valuations (based on the company’s prior private fundraising rounds) to get an idea of what it might be worth. Ultimately though, the same tactics are used as in valuing any other business.

Based on investors’ mindsets, the underwriters get an idea of what price the market will tolerate. They set a share price range, and then during the offer period investors request shares – saying how many they’re willing to buy at a certain price (or they might say they want $10m worth, no matter the price). The underwriters then set the actual price at the level which all the shares will be sold immediately – normally trying to pick as high a price as possible to raise as much money for the company (and boost their fees!). Sometimes the company might set a price slightly below what they can charge, though, as this should lead to a surge in the stock when trading opens, creating a good early impression.

Do the underwriters always get the IPO price right?

Everyone’s fallible. It’s not uncommon for a company to be overhyped, with shares tanking on listing day. This isn’t great for the institutional investors, who bought in at too high a price – but it’s arguably good for the company, as it means they were paid more for their shares than they were really worth.

Ultimately, the IPO process is a balance between undervaluing the shares (meaning the company would be leaving money on the table) and overvaluing the shares (and getting a bad buzz by disappointing people who’d stumped up their cash).

How to trade an IPO

IPOs can be very hard on small investors. The book building process is one of the times that investment banks get to reward their best and biggest clients, so it’s very hard for retail investors to get in on an IPO before the shares start trading publicly. Institutional investors can often buy well below the price at market open (buying at a discount of 25% isn’t unusual), so they’re the ones who reap most of the gains.

How can I invest during the offer period?

Normally the offer period is restricted to large institutional investors (though sometimes friends and family of the company’s employees may get a chance – so start buddying up to your start-up friends).

If you’re a client with one of the underwriters or a broker who receives an allocation you might be able to apply for shares during the offer period, but you’ll probably need to have a very big and active account with them – and for the hottest IPOs, you probably have no chance. To be offered the good IPOs you’re also going to have to take on the bad too, as a lot of this comes down to close personal relationships with underwriters who have a quid-pro-quo attitude.

How do I trade on day one?

As soon as the markets open on listing day, you can buy. If there’s loads of hype and you get in early, you might be able to make a profit that same day. But you’re equally likely to lose out: lots of IPOs end up trading well below their initial price, even over the long term.

Even if you do think the stock is going to tank, you might not be able to bet against it (by shorting the shares) in the same way you can with companies that have been public for a while. That’s because shorting requires borrowing the stock, and in the early days of trading the supply of shares available to borrow is restricted (the underwriters aren’t allowed to lend out shares for the first month, and other investors may not want to).

Because anything could happen, you might be best off waiting for the dust to settle after the first couple of days, and then invest as you would in any other company. Even this comes with a caveat though: prices may fall a bit after the 90-180 day “lockup period” is over, when employees and founders can start selling their shares.

Is trading an IPO stock a good idea?

Legendary investor Warren Buffett has called investing in IPOs “a stupid game”: and listening to the Sage of Omaha is rarely a bad idea…

IPOs can offer a return, but try to keep a cool head and don’t get swept up in the hype that can surround high-profile debuts… don’t be taken in by the emperor’s new clothes!