What is the IPO Process?

The Initial Public Offering IPO Process is where a previously unlisted company
sells new or existing securities and offers them to the public for the first time.

Prior to an IPO, a company is considered to be private – with a smaller number

of shareholders, limited to accredited investors (like angel investors/venture
capitalists and high net worth individuals) and/or early investors (for instance,
the founder, family, and friends).

After an IPO, the issuing company becomes a publicly listed company on a

recognized stock exchange. Thus, an IPO is also commonly known as “going
public”.

Overview of the IPO Process

This guide will break down the steps involved in the process, which can take
anywhere from six months to over a year to complete.

Below are the steps a company must undertake to go public via an IPO
process:

1. Select a bank
2. Due diligence and filings
3. Pricing
4. Stabilization
5. Transition

Step 1: Select an investment bank

The first step in the IPO process is for the issuing company to choose
an investment bank to advise the company on its IPO and to provide
underwriting services. The investment bank is selected according to the
following criteria:

 Reputation
 The quality of research
 Industry expertise
 Distribution, i.e., if the investment bank can provide the issued securities
to more institutional investors or to more individual investors
 Prior relationship with the investment bank

Step 2: Due diligence and regulatory filings

Underwriting is the process through which an investment bank (the

underwriter) acts as a broker between the issuing company and the investing
public to help the issuing company sell its initial set of shares. The following
underwriting arrangements are available to the issuing company:

 Firm Commitment: Under such an agreement, the underwriter

purchases the whole offer and resells the shares to the investing public.
The firm commitment underwriting arrangement guarantees the issuing
company that a particular sum of money will be raised.
 Best Efforts Agreement: Under such an agreement, the underwriter
does not guarantee the amount that they will raise for the issuing
company. It only sells the securities on behalf of the company.
 All or None Agreement: Unless all of the offered shares can be sold,
the offering is canceled.
 Syndicate of Underwriters: Public offerings can be managed by one
underwriter (sole managed) or by multiple managers. When there are
multiple managers, one investment bank is selected as the lead or book-
running manager. Under such an agreement, the lead investment bank
forms a syndicate of underwriters by forming strategic alliances with
other banks, each of which then sells a part of the IPO. Such an
agreement arises when the lead investment bank wants to diversify the
risk of an IPO among multiple banks.

An underwriter must draft the following documents:

Engagement Letter: A letter of engagement typically includes:

1. Reimbursement clause: This clause mandates that the issuing company

must cover all out-of-the-pocket expenses incurred by the underwriter,
even if the IPO is withdrawn during the due diligence stage, the
registration stage, or the marketing stage.
2. Gross spread/underwriting discount: Gross spread is arrived at by
subtracting the price at which the underwriter purchases the issue from
the price at which they sell the issue.

Gross spread = Sale price of the issue sold by the underwriter – Purchase price
of the issue bought by the underwriter

Typically, the gross spread is fixed at 7% of the proceeds. The gross spread is
used to pay a fee to the underwriter. If there is a syndicate of underwriters, the
lead underwriter is paid 20% of the gross spread. 60% of the remaining
spread, called “selling concession”, is split between the syndicate underwriters
in proportion to the number of issues sold by the underwriter. The remaining
20% of the gross spread is used for covering underwriting expenses (for
instance, roadshow expenses, underwriting counsel, etc.).

Letter of Intent: A letter of intent typically contains the following information:

1. The underwriter’s commitment to enter an underwriting agreement with

the issuing company
2. A commitment by the issuing company to provide the underwriter with
all relevant information and, thus, fully co-operate in all due diligence
efforts.
3. An agreement by the issuing company to provide the underwriter with a
15% overallotment option.

The letter of intent does not mention the final offering price.

Underwriting Agreement: The letter of intent remains in effect until the

pricing of the securities, after which the Underwriting Agreement is executed.
Thereafter, the underwriter is contractually bound to purchase the issue from
the company at a specific price.
Registration Statement: The registration statement consists of information
regarding the IPO, the financial statements of the company, the background
of the management, insider holdings, any legal problems faced by the
company, and the ticker symbol to be used by the issuing company once
listed on the stock exchange. The SEC requires that the issuing company and
its underwriters file a registration statement after the details of the issue have
been agreed upon. The registration statement has two parts:

 The Prospectus: This is provided to every investor who buys the issued

security
 Private Filings:  this is comprised of information which is provided to
the SEC for inspection but is not necessarily made available to the public

The registration statement ensures that investors have adequate and reliable
information about the securities. The SEC then carries out due diligence to
ensure that all the required details have been disclosed correctly.

Red Herring Document: In the cooling-off period, the underwriter creates an

initial prospectus which consists of the details of the issuing company, save
the effective date and offer price. Once the red herring document has been
created, the issuing company and the underwriters market the shares to public
investors. Often, underwriters go on roadshows (called the dog and pony
shows – lasting for 3 to 4 weeks) to market the shares to institutional investors
and evaluate the demand for the shares.

Step 3: Pricing

After the IPO is approved by the SEC, the effective date is decided. On the day
before the effective date, the issuing company and the underwriter decide the
offer price (i.e., the price at which the shares will be sold by the issuing
company) and the precise number of shares to be sold. Deciding the offer
price is important because it is the price at which the issuing company raises
capital for itself. The following factors affect the offering price:

 The success/failure of the roadshows (as recorded in the order books)

 The company’s goal
 Condition of the market economy

IPOs are often underpriced to ensure that the issue is fully subscribed/
oversubscribed by the public investors, even if it results in the issuing
company not receiving the full value of its shares.

If an IPO is underpriced, the investors of the IPO expect a rise in the price of
the shares on the offer day. It increases the demand for the issue.
Furthermore, underpricing compensates investors for the risk that they take by
investing in the IPO. An offer that is oversubscribed two to three times is
considered to be a “good IPO.”

Step 4: Stabilization

After the issue has been brought to the market, the underwriter has to provide
analyst recommendations, after-market stabilization, and create a market for
the stock issued.

The underwriter carries out after-market stabilization in the event of order

imbalances by purchasing shares at the offering price or below it.

Stabilization activities can only be carried out for a short period of time –
however, during this period of time, the underwriter has the freedom to trade
and influence the price of the issue as prohibitions against price
manipulation are suspended.

Step 5: Transition to Market Competition

The final stage of the IPO process, the transition to market competition, starts
25 days after the initial public offering, once the “quiet period” mandated by
the SEC ends.
During this period, investors transition from relying on the mandated
disclosures and prospectus to relying on the market forces for information
regarding their shares. After the 25-day period lapses, underwriters can
provide estimates regarding the earning and valuation of the issuing
company. Thus, the underwriter assumes the roles of advisor and evaluator
once the issue has been made.  

Metrics for judging a successful IPO process

The following metrics are used for judging the performance of an IPO:

Market Capitalization: The IPO is considered to be successful if the

company’s market capitalization is equal to or greater than the market
capitalization of industry competitors within 30 days of the initial public
offering. Otherwise, the performance of the IPO is in question.

Market Capitalization = Stock Price x Total Number of Company’s Outstanding

Shares

Market Pricing: The IPO is considered to be successful if the difference

between the offering price and the market capitalization of the issuing
company 30 days after the IPO is less than 20%. Otherwise, the performance
of the IPO is in question.

The Benefits and Costs of Going Public

 
Completing an IPO will often involve significant changes to corporate, capital and management
structures, and once public, a company will be subject to a number of rules and reporting
obligations. With a host of benefits—as well as costs—the decision to go public requires careful
consideration.

Going public has considerable benefits:

 A value for securities can be established
 Increased access to capital-raising opportunities (both public and private financings) and
expansion of investor base
 Liquidity for investors is enhanced since securities can be traded through a public market.
 Publicly traded securities are attractive for certain other purposes (as transaction currency or
executive and employee compensation, for example)
 Credibility and visibility with the public is enhanced, as is the corporate image
 Lower cost of capital relative to debt financing

Although there are many benefits, the costs of going public are considerable–for example:
 Upfront costs of an IPO can be significant. Underwriters’ commissions are typically 4%–7% of
the proceeds of an IPO; their expenses are additional. A company will also incur other offering expenses,
including legal, accounting, printing and filing fees, and will be subject to ongoing costs associated with
public company compliance obligations.
 IPOs lead to greater public disclosure and scrutiny: financial results, share price, management and
director performance, executive compensation, corporate governance practices and insider trading
information will all be available to the public.
 The controlling shareholders’ percentage equity interest and voting interest in the company is
typically lowered – a situation that, among other things, could make the company vulnerable to a control
transaction.
 Extensive management resources are required.
 Transaction freedom is more limited (related party transactions for a public company are
regulated, and listed companies are subject to stock exchange requirements, including requirements for
shareholder approval of certain matters).
 The potential for lawsuits against the directors and management is increased.

IPO
An IPO is the first sale of stock by which a company can go public. The stock is offered for sale to
the general public by the company seeking to raise capital for expansion.
Companies come out with public issue wherein they invite public to contribute towards the equity
and issue shares to meet their fund requirements by sharing ownership with investors. When one
buys shares in the company, he/she becomes shareholders and for that matter owner in the
company by the size of share value.

Advantages:
 IPO allows companies to raise capital by selling shares. Moreover, companies don’t have to
repay the capital raised through the issuance of IPO.
 Companies can offer stock as an incentive, bonus, or as part of an employment contract.
This is sometimes used to retain key people. In addition, equity can be used to purchase or acquire
other businesses.
 By getting listed on a stock exchange business receives wide media coverage enhancing
company’s visibility and recognition of its products and services.

Disadvantages:
 Companies need to disclose critical information including financial information on a regular
basis.
 As public companies have directors who are meant to oversee management’s actions on
behalf of shareholders, in some circumstances actions of management may be limited.
 Going public is an expensive and time consuming process. The legal, accounting and
printing costs are significant and these costs will have to be paid regardless of whether an IPO is
successful or not.

Analyzing an IPO
 Credibility and track record of promoter
 Product and services of the company and their potential
 Past performance of the Company offering the IPO
 Project cost, the means of financing and profitability projections
 Involves risk factors