How IPOs Work


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Sometimes, the business report on the nightly news can sound like it's being given in a foreign language. Ask someone on the street if they've checked the EDGAR data for the Google IPO, and you'll likely get a blank stare.

IPOs are a very important aspect of the U.S. (and world) economy, and they've been around since the late 18th century. In fact, every company with stocks

In this article, we'll find out what an IPO is, why companies have them, and how people and companies make money with them.

What is an IPO?

IPO stands for Initial Public Offering. An IPO happens when a privately owned company issues shares of stock to be sold to the general public. This means the company is no longer privately owned, but is owned by a variety of investors, some of whom are not involved with the day-to-day operations of the company -- these investors simply own some of the company's stock, which they purchased on the open market. Although IPOs can vary greatly from one company to another, and they require a long, expensive and complicated process, the IPO is basically a way for the company to make money based on expectations of future success and profit.

The media's focus on high-profile technology IPOs and Internet-related stocks might lead one to think IPOs are somehow linked to the tech sector. In fact, even the most mundane company can have an IPO, and the first IPOs were held in the 1790s (they were called stock subscriptions at the time). A look at the top U.S. IPOs of all time shows few technology companies and no Internet businesses. Standouts include Pepsi Bottling Group, Kraft Foods, MetLife insurance company, international shippers UPS, and the biggest IPO in U.S. history, the wireless division of AT&T. The IPO for Internet search site Google didn't even approach the top 10, despite the media frenzy that surrounded it.

Why Have an IPO?

The obvious reason that any company has an IPO is to raise money. Why would a company need to raise money?

In the business world, there are as many reasons to raise money as you yourself might have. Think of a few of the reasons you might want to raise $1,000 -- to take a vacation, to pay for important surgery, to make repairs on your house, to invest in a business, or just to buy something you want. Businesses aren't that different, but they operate on a larger scale, and they have different needs and plans that require money. Some of more common reasons that a company might need money, or capital, include:

  • To buy new equipment or upgrade old equipment
  • To expand into a new region or a new kind of business
  • To pay back old debts (and avoid paying the interest on them)
  • As an "exit strategy" for the owner or original investors
  • To make the original owners and investors rich

Upgrading and Expanding

The first two reasons are fairly obvious. Examples could include a bakery that is losing its share of the marketplace because of the low-carb fad. It could have an IPO to raise capital and buy the equipment it needs to make low-carb products and stay competitive. Or imagine a trucking company that is successful shipping along the west coast of the United States -- if it wants to expand its shipping into the Midwest and southwest, it'll need to buy more trucks, hire more drivers, and lease more warehouse space. An IPO could pay for all of these things.

Paying Debts

Using an IPO to repay debts makes a lot of sense if a large portion of the company's initial investment came from a bank loan. Every month, the company's profits are eroded by the interest it has to pay on that loan. There's no interest to pay on the money raised from an IPO; the company can use that money to repay the loan, and that profit-shrinking interest comes right off the balance sheet.

Exit Strategy and Financial Windfall

The last two reasons for having an IPO are closely related. When a company is privately owned, the founders, certain members of the management team (or all the employees, depending on the company) and private investors who helped fund the company all hold shares in the company. Those shares will have little value since they aren't publicly traded. After the company's IPO, those shares can increase in value by a huge margin. In short, anyone who has a lot of those shares could become very rich by selling them.

So what is an exit strategy? Not everyone who starts a business wants to run it forever. Some business owners may just want to get the business going, make it profitable, and then sell their share in the company and move on. Some people do it because they enjoy the challenge of starting new companies. Some just want to get rich and then retire or repeat the process and get richer still. Either way, having an IPO can drastically increase the company's value and make it easier to sell a share in the company.

Money Isn't Everything

There are benefits to having an IPO other than raising capital. When a company's stock goes public, it can attract a lot of media attention. This amounts to free advertising for the company. Also, many publishers of stock market information list and track public companies, which means going public can get a company's name "in the books" and in front of investors and stock brokers.

Issuing shares allows employees to hold stock in a company. The employees know that their share of the company will increase in value the more successful the company is. This gives employees more pride in the work they do -- they literally become part owners. This effect can extend to interested business associates, as well. Imagine that the owner of a packaging business buys stock in the bakery we mentioned above when the bakery has its IPO. The packaging business supplies plastic bags to the bakery, so the owner might be willing to give the bakery a deal on the plastic bags in hopes of helping the bakery become more successful (and increasing the value of his stock).

The last benefit to an IPO has to do with rules established by the Securities Exchange Commission (SEC) that strictly regulate public companies to prevent fraud. To go public, a company has to open its accounting practices, sales figures, and marketing plans to anyone who wants to see them. This can make it easier for the company to secure certain kinds of loans and raise money from other investors.

The Drawbacks of an IPO

Having an IPO doesn't mean free money for the company. Otherwise, everyone would have an IPO. There are drawbacks that come with the new capital raised through an IPO.

The most obvious cost of having an IPO is the expense. It costs money to raise money. The legal fees, printing costs, and accounting fees associated with registering an IPO can run into the hundreds of thousands of dollars. On top of those costs, the rules for taking a company public are so complex that most companies have to hire experts to handle all the paperwork. And once the IPO has happened, the costs don't end. The SEC regulations on public companies mean that the CEO of the company will either have to devote a lot of extra time to dealing with those regulations (plus the demands of profit-hungry shareholders) or hire someone else to do it.

Speaking of shareholders, they are another drawback of going public. The primary owners are no longer in a private company that can make independent decisions. The investors who purchased stocks at the IPO own a certain percentage of the business, and their demands cannot be ignored, even if they don't have a controlling interest (more than 50 percent of the shares) in the company. SEC regulations require shareholder notification, meetings, and approval for certain business decisions. Shareholders also want to see the value of their stocks rise, so if the stock price drops or remains stagnant, the company will have to deal with unhappy part-owners. If they become unhappy enough, they may sell their stocks, which will cause the value to drop further, decreasing the overall value of the company.

Public companies are also open to public scrutiny. Quarterly financial reports, internal transactions, and balance sheets are all open to inspection. This is more of a problem for some companies than others, particularly companies who might have made illegal deals or altered financial reports. To learn about what happens when public scrutiny discovers improper financial dealings, read Open Spaces Quarterly: The Enron Debacle, by Steve McConnel.

Ready, Set, IPO

Having an IPO is not so much an event as it is a process. It takes months of planning to prepare a company to go public. A board of directors must be assembled, accounts audited for accuracy, consultants and advisers hired, and a financial printer contracted. In fact, a whole cast of characters must take the stage to help an IPO happen.

The most important character is probably the underwriter, an investment banker who works for an investment company. Underwriters have the distribution channels and business community contacts that can get a company's shares out to the right investors. They will also help set the initial offering price for the stocks, work to create enthusiasm for the stock, and assist in creating the prospectus. The prospectus is an important document that describes the company in great detail to potential investors.

Once the prospectus has been drafted, it is reviewed by the SEC. SEC approval only means that the prospectus follows the regulations for such documents -- it says nothing about the quality or future profitability of the company.

Following SEC approval, company executives go on the road show, otherwise known as the dog-and-pony show. This is a tour of major cities and cities where important brokerage houses have their headquarters. At these invitation-only slide shows (a few elite investors will even get one-on-one presentations), potential investors are given "goodie bags" containing calendars, pens, samples of the company's product, and whatever else might help investors think favorably about the company. One fashion designer even stocked a road show with famous supermodels.

Although the goodies and supermodels take the spotlight, the road-show crew also includes a Wall Street analyst who will give positive opinions about the company's future profitability. However, no one involved with the company is allowed to talk publicly about anything that isn't in the prospectus in the period leading up to the IPO (Google broke this rule in the weeks leading up to its IPO -- see The Google IPO section to learn more).

The Day of the IPO

The day before the stocks are issued, the underwriter and the company must determine a starting price for the stocks. A target price will have been set early on in the process, but IPOs are rarely stable. Obviously, the higher the price, the more money the company gets; but if the price is set too high, there won't be enough demand for the stocks, and the price will drop on the aftermarket (the open financial markets where the stock will be traded after the initial offering). The ideal stock price will keep demand just higher than supply, resulting in a stable, gradual increase in the stock's price on the aftermarket. This will lead to praise from market analysts, which will in turn lead to increased value down the road.

Who gets to buy the shares during an IPO is a complicated matter. In most cases, your typical, individual investor doesn't get access to these offerings (see The Google IPO to read about an exception). Instead, the underwriter gets to allocate the shares to associates, clients, and major investors of his choosing. Most of the shares (about 80 percent) will go to institutional investors, which are major brokerage firms and investment banks, and a few high-profile individual investors. The remaining shares that do make their way to small-time, individual investors are hard to obtain: Stock brokers usually only offer access to IPOs to higher volume traders, traders with no history of flipping stocks, and traders with a long-term relationship with the broker.

After the initial offering, the stocks hit the open stock market, where they begin trading at a price set by market forces. IPO stocks tend to trade at a very high volume on that first day -- that is, they change hands many times. Some IPOs can jump in price by a huge amount -- some more than 600 percent. Many IPOs do poorly, dropping in price the day of the offering. Others fluctuate, rising and then dipping again -- it all depends on the confidence the market has in the company, how strong the company is vs. the "hype" surrounding it, and what outside forces are affecting the market at the time.

After about a month, the underwriter issues a report on the IPO, which is always positive. This tends to give the stock a slight boost. After 180 days have passed, people who held shares in the company prior to its going public are allowed to sell their shares.

The Google IPO

Image courtesy Google

The IPO of Internet search engine Google wasn't one of the biggest IPOs ever, but it was a media sensation. While many aspects of Google's IPO were standard, it differed in some important ways. Also, Google made some mistakes that affected its IPO.

The biggest difference was in the way Google chose to allocate shares. Instead of letting the underwriter dish out shares to favored institutions, Google held a Dutch auction in which everyone who wanted a share put in a bid. The lowest successful bid became the price that everyone got their shares at, even if they bid a higher amount. This method guarantees that the initial offering price is set to sell all of the shares at a price that conservatively reflects market demand.

Google's initial price range for the stocks was between $108 and $135 per share, a fairly high amount that was meant to scare off speculators. Several well-publicized problems with the IPO caused that price to drop, and by the time the Dutch auction had concluded, the official starting price was $85 per share.

What were the problems with Google's IPO? The first was an interview published in Playboy magazine. This violated SEC rules restricting comments that can be made about a company in the lead-up to an IPO. This could have delayed the IPO, but Google avoided this by admitting that misleading statements were made in the article and by issuing a revised prospectus that contained the entire Playboy article -- a move that probably cost them tens of thousands of dollars in printing costs.

The other mistake was a technical issue regarding the issuance of shares to employees before the IPO. The company failed to register those shares, forcing them to offer to buy them back. The SEC fines companies for this mistake.

However, Google's biggest "mistake" was not playing the usual Wall Street game. The Dutch auction method was meant to give individual investors a chance at the IPO instead of the usual bystander's role, watching from the sidelines as major investors and houses bought up all the shares. It worked, but it left the underwriters and the companies who usually profit from their mutual deals fuming. Google also paid the underwriters a fraction of the commission they usually earn. Since the value of a stock depends in part on the efforts of these Wall Street insiders to convince others of that value, Google's refusal to play ball surely had an effect on the stocks' valuation.

So how much money did the Google IPO make? For the company, it raised $1.67 billion, rising to a value of more than $100 per share in the days after the IPO. But here's another way to look at it: Google employees purchased shares for as little as $.30 per share when it was still a private company. Someone who had just 10,000 Google shares is now a millionaire.

For more information on IPOs and related topics, check out the links on the next page.

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Sources

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