x
Close

Recent Posts

Financial Literacy

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

The IPO Process: A Step-by-Step Guide to Going Public
ByAmber Deter
  • PublishedJanuary 10, 2020

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. Securities and Exchange Commission (SEC) registered banks 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. Basically, it’s the difference between the price the underwriter paid and the price they sold the shares 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% over-allotment 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 set, the underwriter is legally bound to purchase the shares at the agreed-upon price.

S-1 Registration Statement

This paperwork needs to go through filing with the SEC. It is mandatory. There are two parts:

  1. Information Required in Prospectus — The prospectus is a legal document provided to everyone who gets offered and/or buys the stock. It must clearly describe the company’s business operations, financial state, operations results, risk factors and management. In addition, it must include audited financial statements.
  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 value of the company determines the price. The valuation process 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 underprice its shares. 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

With everything decided, the IPO is ready 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 that underwriters use:

Greenshoe Option

In the letter of intent, there is a clause that allows an over-allotment 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. You can find this in the contract with the company under the over-allotment clause.

Overallotment is a popular choice because it’s both SEC-permitted and risk-free. While over-allotment 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 noted that when a company goes public, anyone who already owned shares could cash out. However, those shares can only go for sale 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.

Furthermore, if IPO investing interests you, check out our top recent IPOs and our IPO calendar. We update it daily to give you the latest news on upcoming and filed IPOs.

Written By
Amber Deter

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.

Prev Post

Next Post

181 Comments

Leave a Reply

Related Posts

Optimal Asset Allocation: How To Build A Strong Portfolio Using Four Basic Strategies
Financial Literacy
June 6, 2002

Optimal Asset Allocation: How To Build A Strong Portfolio Using Four Basic Strategies

How to Follow the Stock Market… and Get the Big Picture
Financial Literacy
January 14, 2003

How to Follow the Stock Market… and Get the Big Picture

16 Must-Read Investment Books: The Foundation of Your Future Profits
Financial Literacy
April 11, 2003

16 Must-Read Investment Books: The Foundation of Your Future Profits