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Public funding - IPO

Page history last edited by Brian D Butler 12 years, 10 months ago

Table of Contents:





Initial public offering

An initial public offering (IPO) is the first sale of a corporation's common shares to public investors. The main purpose of an IPO is to raise capital for the corporation. While IPOs are effective at raising capital, they also impose heavy regulatory compliance and reporting requirements. The term only refers to the first public issuance of a company's shares; any later public issuance of shares is referred to as a Secondary Market Offering. A shareholder selling its existing (rather than shares newly issued to raise capital) shares to public on the Primary Market is an Offer for Sale.



IPOs generally involve one or more investment banks as "underwriters." The company offering its shares, called the "issuer," enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.

The sale (that is, the allocation and pricing) of shares in an IPO may take several forms. Common methods include:


* Dutch auction

* Firm commitment

* Best efforts

* Bought deal

* Self Distribution of Stock


A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold. Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases. Multinational IPOs may have as many as three syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. (e.g., an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually the lead underwriter in the main selling group is also the lead bank in the other selling groups.)


Because of the wide array of legal requirements, IPOs typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and the white shoe firms of New York City.


Usually the offering will include the issuance of new shares, intended to raise new capital, as well the secondary sale of existing shares. However, certain regulatory restrictions and restrictions imposed by the lead underwriter are often placed on the sale of existing shares.


Public offerings are primarily sold to institutional investors, but some shares are also allocated to the underwriters' retail investors. A broker selling shares of a public offering to his clients is paid through a sales credit instead of a commission. The client pays no commission to purchase the shares of a public offering, the purchase price simply includes the built in sales credit.


The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe or over-allotment option.


Legal requirements in the United States

The United States has the strictest legal regime in the world governing IPOs. Moreover, federal securities law applies not only to IPOs within the U.S., but to any IPO in the world that targets or is likely to target a large number of U.S. investors. As a result, many IPOs are structured and timed around U.S. legal requirements, even if they do not actually occur in the U.S. or involve a U.S. company.


Under U.S. law, the IPO process is governed by the Securities Act of 1933 and the regulations of the Securities and Exchange Commission; each stock exchange has separate rules that listing companies must follow. Smaller IPOs may also be significantly affected by state blue sky laws; these laws are usually pre-empted by federal law when the stock is to be listed on a major exchange or NASDAQ, but apply fully to certain medium-scale offerings on a local level.


Before the IPO begins in earnest, the issuer must draft a prospectus. The prospectus is a detailed overview of the company's finances, history, operations, products, risk factors, industry environment, and other information.


Under the Securities Act, until an IPO is registered with the SEC, no public offering of any kind may be made by the issuer or its underwriters. Any offering during this "quiet period" is called "gun-jumping." After filing, the issuer and underwriters may advertise the IPO through a simple "tombstone" advertisement, listing the name of the company, the amount of stock being offered, the names of the underwriters, and other basic information. Private placement discussions and limited press releases are also permitted. Any written offers to sell stock must be accompanied by a copy of the prospectus as submitted to the SEC, which is usually stamped with a warning of its non-final status in red letters and therefore called a "red herring."


Once the SEC approves the prospectus, the price of the shares is finalized and the IPO enters a "free riding" period in which shares may be offered for sale in a number of ways, such as telephone calls, "road shows" and institutional visits. All offers must be accompanied by a copy of the prospectus. False and misleading statements are strictly prohibited while offering shares during this period.


The issuer is liable for any misstatement or omission in the prospectus; its directors, officers and underwriters may also be liable if they fail to undertake a "reasonable investigation," or if they had reasonable ground to believe the statement wasn't true or the omission was significant. Underwriters may defend against liability by completing a due diligence investigation of the issuer, usually involving outside lawyers and accountants.



Legal requirements in the European Union

The European Union does not have a central regulatory mechanism for IPOs, but has made several steps toward unifying European laws relating to IPOs, most notably the Prospectus Directive of 2003. 1


In Europe, underwriters generally face joint and several liability for the underwriting of all the offered securities. This differs from the U.S. rule, where each underwriter is separately liable for their allotted portion of the offering.


Business cycle

In the United States, during the dot-com bubble of the late 1990s, many venture capital driven companies were started, and seeking to cash in on the bull market, quickly offered IPOs. Usually, stock price spiraled upwards as soon as a company went public, as investors sought to get in at the ground-level of the next potential Microsoft and Netscape.


Initial founders could often become overnight millionaires, and due to generous stock options, employees could make a great deal of money as well. The majority of IPOs could be found on the Nasdaq stock exchange, which is laden with companies related to computer and information technology.


This phenomenon was not limited to the United States. In Japan, for example, a similar situation occurred. Some companies were operated in a similar way in that their only goal was to have an IPO. Some stock exchanges were set up for those companies, such as Nasdaq Japan.


Perhaps the clearest bubbles in the history of hot IPO markets were in 1929, when closed-end fund IPOs sold at enormous premiums to net asset value, and in 1989, when closed-end country fund IPOs sold at enormous premiums to net asset value. What makes these bubbles so clear is the ability to compare market prices for shares in the closed-end funds to the value of the shares in the funds' portfolios. When market prices are multiples of the underlying value, bubbles are clearly occurring.



A venture capitalist named Bill Hambrecht has attempted to devise a method that can reduce the inefficient process. He devised a way to issue shares through a Dutch auction as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters however have not taken to this strategy very well. Though not the first company to use Dutch auction, Google is one established company that went public through the use of auction. Its share price rose 17% in its first day of trading despite the auction method. Perception on IPOs can be controversial depending on one's point of view. For those who view a successful IPO to be one that raised as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open market. More institutions bid, fewer private individuals bid. Google may be a special case as many individual investors bought the stock based on long-term valuation shortly after it IPO'd, driving it beyond institutional valuation.



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 leads to massive gains for investors who enter the IPO early. 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.


Books about Venture Capital / Private Equity


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