Answering the most common questions about public offerings and investigating the pros and cons of investing into initial public offerings.
There is usually a lot of excitement when a new company starts offering its shares on a public stock exchange. However while some excitement might be justified a healthy dose of skepticism never hurts. This post investigated the advantages and risks of investing into a company‘s IPO.
An initial public offering (IPO) is the process of a company offering new company shares on a stock exchange to individual, private investors for the first time. Many companies turn to IPOs as a way to raise more capital, for example in order to sustain rapid growth. Other uses of the raised capital can be the repayment of debt or to use it as working capital.
To become a public company the company has to register its shares with the SEC or a similar regulatory body. Once the shares have been registered the company is considered to be public. A company without any registered shares is considered a private company.
A private company tends to have relatively few shareholders, for example the original founders as well as angel investors and venture capitalists. For many early investors into private companies an IPO is the best time to fully realize their gains from their early investment.
A public company is not limited to a single public offering. As long as existing shareholders approve the issuing of new shares a company can register and sell new shares to the public at any time. Hence only the first public offering is deemed the initial public offering and associated with the company going public. No subsequent public offerings result in the company going public again.
Being public also does not mean that all shares of the company have been registered. Some shares might still be unregistered and privately held.
In a public offering new or existing shares will be sold to the public. This requires the company to register their shares with the SEC or similar regulatory bodies. In a private placement this registration is not needed. Instead the shares are being sold to private individuals or financial institutions without requiring the time-consuming and costly process of registering the shares.
The advantage of a private placement for companies is that it will be able to raise capital quickly. It also avoids to reveal information it doesn’t want to disclose as no statements have to be disclosed in a prospectus.
In order to offer its shares to investors they have to be first registered with the Securities and Exchange Commission (SEC).
This means the company has provide the following information to the SEC:
The prospectus only contains information about the past performance of the company and therefore investors have to make their own projections regarding the future potential of the company. The SEC also does not validate the information presented in the prospectus. However if the information is found to be fraudulent investors who bought based on the prospectus may be able to receive their money back and return the shares.
While the SEC reviews the provided information the company is considered to be “in registration”. Once the SEC approved the prospectus the registration is considered to be “effective” and the company is free to offer its shares to investors. Once the shares have been sold they are registered forever and can be resold without another registration.
By using a shelf registration a company can file all required registration statements early and get it approved without having to offer the shares immediately to the public. Instead management can decide when the right time has come for selling the shares.
A common reason for a shelf registration is that a company expects to need capital soon but wants to wait for the stock price to rise before selling new shares. This allows it to profit from favorable market conditions on shorter notice.
In order to create a shelf registration the company has to prepare a base prospectus which has to be updated with a prospectus supplement once the shares will be sold.
As the registration process is a long and expensive process a company will usually enlist one or more investment banks for their help. This group of investment banks is usually led by the biggest investment bank of the group and referred to as “underwriters”. They will help the company to determine the ideal initial price, offer it to potential investors, register the shares with the SEC and list them on a stock exchange.
Once shares have been registered the underwriters will confirm the purchase of shares with their clients. This step is necessary as the shares cannot be legally sold before the registration. Until the registration is effective investors can back out at any time.
In some cases the underwriter will form an “underwriting syndicate” which will buy the entire issue of shares from the company and then resell or distribute them to buyers.
These shares will then be distributed to other investment bankers and stockbrokers which will sell them to their clients. This reduces risk as more clients have access to the shares and the likelihood of unsold shares goes down. It also splits the risk between all members of the underwriting syndicate.
The underwriting syndicate only consists of those dealer who will purchase shares from the company. Dealers who will sell as many shares as they can but return unsold shares are not part of the syndicate.
Theoretically a company can set any initial offering price for their public offering. After the shares have been sold the price will be based on investor expectations amongst other factors influencing share prices. However the initial price will primarily depend on supply and demand. This supply and demand will be influenced by the outlook of the company. A company which has to reduce debt and assure its survival will need to offer a more attractive price than a highly successful company.
The investment bankers will help to determine the right price by offering the shares to potential investors. Based on their feedback the price is then adjusted prior to their sale. If the price ends up too high not all of the shares might be sold. A lower price on the other hand might lead to a great demand and a rise in price immediately after the stock is traded on the exchange.
Another consideration is the number of issued shares. Ideally a company wants the shares to be widely held in order to produce an active market for the shares. This ensures liquidity which makes it easier for existing shareholder to sell their stock. In order to avoid volatile prices a chunk of the shares will also be offered to institutional investors who will hold the stock for longer periods.
From the view of existing shareholders the price should also be as high as possible in order to raise the required shares with as little newly created shares as possible. This will reduce the impact of dilution for them.
A company may decide to sell shares to the public for two reasons:
Many public stock offerings are combining primary and secondary offerings in which a company gains access to capital by selling new shares and existing shareholder cash out their early private investment.
Investors will hope for the shares to trade at a high price-to-earnings ratio in case they sell their shares during the public offering. This enables the existing shareholders to receive cash today which would otherwise take years to receive in dividends. Receiving cash for their investments early is important due to the time value of money.
In a primary offering the company gains access to capital markets by offering new shares to investors. In this case existing shareholders will be diluted as the amount of outstanding shares increases. Contrary, in a secondary offer existing shareholder will sell their shares to the public.
In the case of a primary offering the proceeds of the sale of shares goes to the company while in a secondary offering the proceeds go to the existing shareholders.
As new shares are being created in a primary offering there is no limit on the amount of public offerings of a company. The only condition is that existing shareholders authorize the issue of the new shares. Similarly there is no limit on the amount of secondary offers. Technically each sale of shares from one investor to another is a secondary offer.
A secondary offering is also referred to as a direct listing. As existing shares are being sold a direct listing is usually cheaper to organize as the underwriting process is less complex. It also avoid dilution for other existing shareholders as no new shares are being created.
A special purpose acquisition vehicles (SPAC) is a company which is solely founded for the purpose of raising money through an IPO. The raised funds are then being used to acquire a company. As the SPAC is solely founded to raise funds for a company acquisition they have no running business operations at the time of the IPO.
Once the SPAC acquires a company the acquired company becomes a public company without the need to manage an IPO. As the SPAC has no running business operations acquiring another company is comparatively quick and cheap. This stands in contrast to a traditional IPO in which a private company goes public by issuing new shares which can be both a lengthy and expensive process.
A SPAC has two years to complete the acquisition of another company. If the acquisition has not happened afterwards the SPAC has to return the funds to their investors.
Although SPACs have been around for quite some time they habe become quite popular recently and are especially being used by young companies to go public.
When Facebook had its IPO in 2012 at a price of $38 some investors argued that the company is overpriced and overhyped. However today it trades at around $325. According to a recent Investopedia article investors who invested in the IPO would have achieved an annual return rate of 23.3% by 2020. This is significantly more than the average annual return rate of 10%.
One main disadvantage of investing into an IPO is the lack of a stock trading history. Without the trading history investors have to put in more effort to judge the value of the newly listed company. The lack of a trading history also makes investing into an IPO riskier than investing into a more established company.
Usually an IPO can attract a lot of interest causing the stock price to skyrocket unreasonably. However as many early investors of the company use the IPO as an exit strategy they tend to sell their shares in the IPO. This can cause the price to fall shortly after. As a result investors who invest at the highest price can end up with big losses.
Investors should be cautious when investing in IPOs. It might be better to wait out for a few weeks or months after an IPO to perform a valuation of the company and understand the trading history before investing into a newly listed company.
“IPO means It's Probably Overpriced”
A recent example of this is the Coinbase (COIN) IPO on April 14th 2021. On that day the price had risen to lose to $400 per share and since has fallen to around $300 causing losses for investors.
Learn more about fundamental investing concepts in this recommended post.