Initial Public Offering (IPO)
IPO is the first sale of stock by a private company to the public. IPOs
are often issued by smaller, younger companies seeking capital to expand,
but can also be done by large privately-owned companies looking to become
publicly traded.
In an IPO, the issuer may obtain the assistance of an underwriting firm,
which helps it determine what type of security to issue (common or preferred),
best offering price and time to bring it to market.
Also referred to as a "public offering".
IPOs can be a risky investment. For the individual investor, it is tough
to predict what the stock will do on its initial day of trading and in
the near future since there is often little historical data with which
to analyze the company. Also, most IPOs are of companies going through
a transitory growth period, and they are therefore subject to additional
uncertainty regarding their future value.
Reasons for listing
When a company lists its shares on a public exchange, it will almost
invariably look to issue additional new shares in order to raise extra
capital at the same time. The money paid by investors for the newly-issued
shares goes directly to the company (in contrast to a later trade of shares
on the exchange, where the money passes between investors). An IPO, therefore,
allows a company to tap a wide pool of stock market investors to provide
it with large volumes of capital for future growth. The company is never
required to repay the capital, but instead the new shareholders have a
right to future profits distributed by the company.
The existing shareholders will see their shareholdings diluted as a proportion
of the company's shares. However, they hope that the capital investment
will make their shareholdings more valuable in absolute terms.
In addition, once a company is listed, it will be able to issue further
shares via a rights issue, thereby again providing itself with capital
for expansion without incurring any debt. This regular ability to raise
large amounts of capital from the general market, rather than having to
seek and negotiate with individual investors, is a key incentive for many
companies seeking to list.
Pricing
Historically, IPOs both globally and in the US have been underpriced.
The effect of underpricing an IPO is to generate additional interest in
the stock when it first becomes publicly traded. This can lead to significant
gains for investors who have been allocated shares of the IPO at the offering
price. However, underpricing an IPO results in "money left on the
table"lost capital that could have been raised for the company had
the stock been offered at a higher price.
The danger of overpricing is also an important consideration. If a stock
is offered to the public at a higher price than what the market will pay,
the underwriters may have trouble meeting their commitments to sell shares.
Even if they sell all of the issued shares, if the stock falls in value
on the first day of trading, it may lose its marketability and hence even
more of its value.
Investment banks, therefore, take many factors into consideration when
pricing an IPO, and attempt to reach an offering price that is low enough
to stimulate interest in the stock, but high enough to raise an adequate
amount of capital for the company. The process of determining an optimal
price usually involves the underwriters ("syndicate") arranging
share purchase commitments from lead institutional investors.
How is the issue price decided on?
A company that is planning an IPO appoints lead managers to help it decide
on an appropriate price at which the shares should be issued. There are
two ways in which the price of an IPO can be determined either the company,
with the help of its lead managers, fixes a price or the price is arrived
at through the process of book building.
Note: Not all IPOs are eligible for delivery settlement through the DTC
system, which would then either require the physical delivery of the stock
certificates to the clearing agent bank's custodian, or a delivery versus
payment ("DVP") arrangement with the selling group brokerage
firm. This information is not sufficient.
Quiet Period
There are two time windows commonly referred to as "quiet periods"
during an IPO's history. The first and the one linked above is the period
of time following the filing of the company's S-1 but before SEC staff
declare the registration statement effective. During this time, issuers,
company insiders, analysts, and other parties are legally restricted in
their ability to discuss or promote the upcoming IPO.[1]
The other "quiet period" refers to a period of 40 calendar
days following an IPO's first day of public trading. During this time,
insiders and any underwriters involved in the IPO, are restricted from
issuing any earnings forecasts or research reports for the company. Regulatory
changes enacted by the SEC as part of the Global Settlement, changed the
quiet period to 40 days from 25 days on July 9, 2002. When the quiet period
is over, generally the lead underwriters will initiate research coverage
on the firm.
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