What Is An IPO?

An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO. Companies fall into two broad categories, private and public.

A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company, just put in some money, files the right legal documents and follows the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public."

Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market, like any other commodity. If you have the cash, you can invest."

What Is An IPO?

Going public raises cash, and usually a lot of it. Being publicly traded also opens many financial doors:

• Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
• As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.
• Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.

Being on a major stock exchange carries a considerable amount of prestige. In the past, only private companies with strong fundamentals could qualify for an IPO and it wasn't easy to get listed.

Getting In On An IPO

Getting a piece of a hot IPO is very difficult, if not impossible. To understand why, we need to know how an IPO is done, a process known as underwriting.

When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters as middlemen between companies and the investing public. The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement.

The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.

Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the SEBI. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used and insider holdings. Once SEBI approves the offering, a date (the effective date) is set when the stock will be offered to the public.

During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue.

As the effective date approaches, the underwriter and company sit down and decide on the price. This isn't an easy decision it depends on the company and most importantly current market conditions. Of course, it's in both parties' interest to get as much as possible.

Finally, the securities are sold on the stock market and the money is collected from investors.

Don't Just Jump In

Let's say you do get in on an IPO. Here are a few things to look out for.

No History

It's hard enough to analyze the stock of an established company. An IPO company is even trickier to analyze since there won't be a lot of historical information. Your main source of data is the red herring, so make sure you examine this document carefully. Look for the usual information, but also pay special attention to the management team and how they plan to use the funds generated from the IPO.

And what about the underwriters? Successful IPOs are typically supported by bigger brokerages that have the ability to promote a new issue well. Be more wary of smaller investment banks because they may be willing to underwrite any company.

The Lock-Up Period

If you look at the charts following many IPOs, you'll notice that after a few months the stock takes a steep downturn. This is often because of the lock-up period.

When a company goes public, the underwriters make promoters and employees in case ESOP to sign a lock-up agreement. Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The problem is, when lockups expire all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.

IPO Basics: Conclusion

Let's review the basics of an IPO:

• An initial public offering (IPO) is the first sale of stock by a company to the public.
• Broadly speaking, companies are either private or public. Going public means a company is switching from private ownership to public ownership
• Going public raises cash and provides many benefits for a company
• Getting in on a hot IPO is very difficult, if not impossible.
• The process of underwriting involves raising money from investors by issuing new securities.
• Companies hire investment banks to underwrite an IPO.
• An IPO company is difficult to analyze because there isn't a lot of historical info.
• Lock-up periods prevent insiders from selling their shares for a certain period of time. The end of the lockup period can put strong downward pressure on a stock.
• Flipping may get you blacklisted from future offerings.
• Road shows and red herrings are marketing events meant to get as much attention as possible. Don't get sucked in by the hype.