The Underwriting Process For a Public Offering (IPO)

Private companies sometimes want to issue their stock to members of the public in order to raise capital.  Companies can go public by making an Initial Public Offering.  A central part of an IPO is underwriting, a process in which a bank buys the company’s stock at a fixed price and resells it.

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 In a common type of IPO, called a “firm commitment,” the underwriting institution will commit to buying all the shares the company is issuing, and the institution assumes any risk for shares that do not sell.  After arriving at a price suitable to sell the stock, the company sells it to the institution at a discount, usually around 7%.  Selling the discounted stock at its full offering price enables the underwriters to make their fee.  Otherwise, a bank can sell shares under a “best efforts” agreement in which the bank will use its best efforts to sell the shares, but will not assume the risk for unsold shares.  If a stock offering is too big for one institution to manage, the institution could gather other banks into an underwriting syndicate to provide additional management of the sale.  

Initially, the company must determine the total amount of money it seeks to raise with the IPO.  The company and the institution must then determine how much dilution (the reduction in owners’ control over the company that occurs when some of their stock is sold), they will tolerate, and thus how many shares they could sell.  Considering the value of the entire company, how much capital it needs, and how much stock the company is willing to part with, the underwriters then determine the number of shares within a certain price range that will raise that amount.  In an effort to market the IPO to investors, the underwriters and company will draft a prospectus that states financial figures, business operations information, and stock information.

Companies seeking to issue IPOs will then perform “road shows,” in which representatives will travel the country, and sometimes abroad, to market the company to investors to create interest in buying the company’s stock.  These presentations can be crucial to the IPO’s success.  Investors have a chance to see the company’s senior management advocating on behalf of their company, and thus will develop opinions on the company’s strength based on both the financial and business information presented and the confidence the investor has in the managers. 

After the road shows, the underwriters and company management will price the stock.  Two major factors to determine this number are how other similar companies priced their stock when going public, and how much interest the underwriter expects investors to have in the new stock.  Interest in the stock has been continually gauged during this process.  The institutions handling the sale collected information about investor interest before writing the prospectus and during the road shows.  If demand has been consistently strong or has strengthened, the bank will suggest offering the stock at a higher price.  External market factors affect the determination as well. 

Finally, when the price is set and all the SEC formalities have been completed, the stock will be included in a stock exchange to be traded. 

            

When to Know to Take Your Company Public

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In an Initial Public Offering (“IPO”), a private company sells its stock to the public.  Companies usually use an IPO to raise capital so they can expand or to become a publicly traded company.  As a public company, its stock can be traded via a stock exchange.  One effect of this is that publicly traded companies often have many shareholders, whereas private companies might have only a few.  

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The primary advantage of becoming a publicly traded company is the ability to raise capital.  An initial public offering can raise millions of dollars for a company if it fetches a 100% or 500% increase on its stock offering price (e.g., if the company prices the stock at $7 per share, and it later sells for $50 per share).  Also, as the stock’s value increases, it becomes more “liquid,” enabling the investors to use it more like currency, in turn decreasing the need to use cash to obtain needed assets.  Going public will also create publicity for the company. 

Further, offering shares to the public allows the owners to retain the same management, whereas if the company sold securities to another business, that business might want to place some of its personnel on the board of directors.  Thus, issuing an IPO can enable the company to retain decision making authority over its business.  

But public companies are not more advantageous than privately held companies in every way.  Public companies must file quarterly and annual financial statements with the Securities and Exchange Commission.  The SEC in turn uses this information to ensure that the company is not defrauding or misleading investors into believing the company is worth more than it is in fact.

Going public requires companies to comply with many legal rules and can cost a large sum of money.  First, the company has to register with the SEC and await the SEC’s approval of its registration.  Completing a registration statement requires the company to compile many records, including bylaws, information about any litigation involving the company, board meeting records, and an array of personnel information.  It will then need to market itself to investors.  The company must employ underwriters to price its stock accurately so that the price will be high enough to raise money for the owners but low enough so traders will purchase it.  The legal, accounting, and underwriting costs, in addition to SEC filing fees, make the entire process quite expensive.  In 2007, for example, the average overall cost to complete an IPO totaled an average of $2.85 million.     

The company might have to hire additional employees to ensure that it complies with the legal rules that govern public companies.  Laws require the company to report certain transactions, management practices, and executive compensation, among other matters.  Further, this effort will require the company to keep better records, and in the process, the company’s operation will lose some flexibility. 

Finally, the extensive disclosure of business operation information can benefit competitors by providing information that allows other businesses to infer the company’s business strategies and the business’s strengths and weaknesses. 

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