Diversifying investments will allow entrepreneurs to receive varied sources of income in the short and long term. An investment in an initial public offering has the potential to generate attractive returns. However, before you invest, you need to understand the rules associated with the IPO process, the additional risks, and how the process of trading these securities differs from ordinary stock trading.
In this article, you will learn about the IPO process, the advantages and disadvantages of this process, what to expect when you invest in these securities, the reasons why a company goes public, as well as how we can help you learn more about this matter.
- What is the IPO process?
- How does an IPO process work?
- The Initial Public Offering process
- Benefits and challenges of an IPO
- Why does a company go public?
- What to expect when you invest in an Initial Public Offering?
- How can we help you learn more about IPOs?
1. What is the IPO process?
An Initial Public Offering is a process of a public offering of shares of a private corporation in a new issue of shares. This offering allows a company to raise capital from public investors. The transition from a private to a public company can be an important process for private investors to fully realize the return on their investment, as it typically includes an issue premium for current private investors. In the meantime, it also allows new entrepreneurs to enter this offering.
Some key aspects of this process are the following:
- Companies hire investment banks to gauge demand, set the price and date of the Initial Public Offering, and more.
- An Initial Public Offering can be seen as an exit strategy for early investors and company founders, who get the full benefit of their private investment.
- Companies must meet the requirements of exchanges and the Securities and Exchange Commission (SEC) to conduct an initial public offering.
- IPOs provide companies with the opportunity to raise capital by offering shares through the primary market.
- The IPO meaning is “Initial Public Offering” and refers to the process of offering shares of a private company to the public in a new issue of shares.
2. How does an IPO process work?
Before an Initial Public Offering, you can consider a company private. As a pre-IPO private company, the business has grown with a low number of shareholders, including early investors like the founders, friends, and family along with professional investors such as angel investors or venture capitalists.
This kind of offering is an important step for a company as it provides access to a lot of money. This gives the business a greater ability to expand and grow. The share listing credibility and increased transparency can also be a factor in helping in obtaining better terms when seeking borrowed funds as well.
When a company reaches a stage in its growth process where it thinks it is ready for the rigors of SEC regulations along with the responsibilities and benefits to public shareholders, it will start to promote its interest in going public.
Generally, this stage of growth will occur when the company reaches a private valuation of approximately $1 billion, people call this the unicorn status. However, private companies with various proven profitability potential and strong fundamentals can also qualify for an Initial Public Offering, depending on their ability to meet listing requirements and the market competition.
The Initial Public Offering shares of a business are priced through underwriting due diligence. When a company stops being private, the previously owned share ownership converts to public ownership. And the existing private shares become worth the public trading price.
Meanwhile, the public market opens up great opportunities for hundreds of investors to buy shares in the company and contribute capital to the shareholders’ equity of a company. The public consists of every person who wants to invest in the business. Overall, the shares the company sells and its prices are the generating factors for the company’s new equity value.
3. The Initial Public Offering process
This comprehensive process consists of two parts. The first part is the pre-marketing phase of the offering, while the second part is the IPO itself. When a business has an interest in the process, it will advertise to underwriters by soliciting private bids or it can also make a public statement to generate interest.
The company chooses the underwriters and they lead the IPO process. The business may choose one or many underwriters to manage different parts of the process collaboratively. The underwriters are involved in every aspect of the initial public offering, document preparation, due diligence, filling, marketing, and issuance.
Some of the steps to perform this procedure are the following:
Underwriters present valuations and proposals discussing their services, the best type of security to issue, the number of shares, the offering price, and the estimated time frame for the market offering.
The business chooses its underwriters and formally agrees to underwrite terms through an underwriting agreement.
Initial public offering teams are made up of lawyers, underwriters, certified public accountants (CPAs), and Security and Exchange Commission (SEC) experts.
Information about the company is gathered for the required IPO documentation. The Registration Statement is the first document you need to take care of. It has two parts, the private held filing information, and the prospectus.
The Registration Statement includes preliminary information about the expected date of the filing. It will be revised often throughout the pre-initial public offering process. The included prospectus is also revised continuously.
3.5 Marketing and updates
Marketing materials are used for pre-marketing of the new share issuance. Executives and underwriters market the share issuance to estimate the demand and establish a final offering price. The underwriters can review their financial analysis throughout the marketing process. This may include changing the issuance date or the initial public offering price as they see fit.
Businesses take the necessary steps to meet specific public share offering requirements. The companies must adhere to SEC requirements for public companies and the exchange listing requirements.
3.6 Boards and processes
Form a board of directors and ensure processes for reporting accounting and auditable financial information every quarter.
3.7 Shares issued
The business issues its stocks on an initial public offering date. The stakeholders receive the capital from the primary issue as cash and record it as stockholders’ equity on the balance sheet. Subsequently, The value of the shares on the balance sheet becomes dependent on the valuation of the capital per share of the company’s shareholders.
Some post-IPO provisions may be instituted. Underwriters may have a specific time frame to buy the number of shares after the initial public offering date. Meanwhile, certain entrepreneurs may be the subject in some periods.
4. Benefits and challenges of an IPO
The objective of an initial public offering is to gain extra capital for a company. It can also come with other benefits, but also disadvantages.
One of the main advantages is that the company gets access to investment from the entire investing public to raise capital. This increases the company’s exposure, and public image, which can help the company’s profits and sales and facilitates acquisition deals.
Also, the full transparency that comes with the required quarterly reporting can, generally, help a company receive more favorable credit borrowing terms than a private company.
Some specific advantages are the following:
- Retain and attract skilled employees and better management through liquid stock equity participation (e.g ESOPs)
- You can raise additional funds in the future through secondary offerings.
- An initial public offering can give a company a lower cost of capital for both debt and equity.
Businesses can confront several disadvantages to going public and potentially choose alternative strategies. Some of the biggest drawbacks include the costs of maintaining a public company ongoing and the fact that Initial Public Offerings are expensive.
Fluctuations in the share price of a company can distract management, which can be evaluated and compensated based on stock performance, rather than real financial results. As well, the company requires to disclose accounting, financial, tax, and other business information. During these disclosures, it may have to publicly reveal business methods and secrets that could help competitors.
Strict governance and leadership by the board of directors can make it more difficult to keep proper managers willing to take risks. Remaining private is always an option. Instead of going public, the businesses may also request bids for a buyout. In addition to this, there may be some alternatives that companies may explore.
Some specific disadvantages are the following:
- The increased effort, time, and attention required of management for reporting.
- Significant marketing, accounting, and legal costs arise, many of which are ongoing.
- There are stronger agency problems and frequent loss of control.
5. Why does a company go public?
5.1 Raise capital for expansion and growth
Every business needs money to create new products, pay off existing debts or increase its operations. Going public is the ideal way to earn the much-needed money for the company.
5.2 Allowing owners and early investors to sell their stakes to make money
Going public is an exit strategy for venture capitalists and initial investors. A business becomes liquid through the sale of stocks in an initial public offering. The capitalists sell their shares in the company at this time to reap returns and exit from the business.
5.3 Greater public awareness
Initial public offerings are in the stock market calendar. There is a lot of publicity and buzz around these events. This is a great way for a company to advertise its services and products to its new set of customers in the market.
6. What to expect when you invest in an Initial Public Offering?
When a company decides to raise money via an Initial Public Offering, it is only after careful consideration. This exit strategy will raise the most capital for the business and maximize the returns of early investors. Therefore, when it is decided to carry out the Initial Public Offering, the prospects for future growth are likely to be high.
The Initial Public Offering is, generally, discounted to ensure sales, which makes them more attractive. Especially when they generate a lot of buyers from the primary issue. Initially, the price of the IPO process is, generally, set by the underwriters through the pre-marketing process. At its core, the Initial public offering price is based on the valuation of the company using certain fundamental techniques. The most common is discounted cash flow, which is the net present value of the future cash flows of the company.
Interested investors and underwriters look at this value on a per-share basis. Other methods you can use for setting the price include enterprise value, comparable firm adjustment, equity value, and more. The underwriters do factor in demand but they also discount the price to ensure success on the Initial Public Offering day.
6.1 Tips for entrepreneurs investing in Initial Public Offering
It can be quite hard to analyze the technicals and fundamentals of an Initial Public Offering issuance. The entrepreneurs may watch new headlines, but the main source of information should be the prospectus, which is available as soon as the company files its Registration Statement. The prospectus provides a lot of useful information.
The entrepreneurs should pay more attention to the management team and their commentary, as well as the specifics of the deal and the quality of the underwriters.
Successful IPOs will, generally, get support from big investment banks that can promote a new issue well. Overall, the road to an initial public offering is a very long one. As such, investors can follow developing headlines and other information along the way to help supplement their assessment of the best and potential offering price.
7. How can we help you know more about IPOs?
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