How Does an IPO Work?
By: Casey Botticello
Tags: Investing, Business, Finance, Venture Capital, Government

An initial public offering, or IPO, is the very first sale of stock issued by a company to the public. Prior to an IPO, the company is considered private, with a relatively small number of shareholders made up primarily of early investors (such as the founders, their families and friends) and professional investors (such as venture capitalists or angel investors).

The public offering, on the other hand, consists of everybody else — any individual or institutional investor who wasn’t involved in the early days of the company and who is interested in buying shares of the company. Until a company’s stock is offered for sale to the public, the public is unable to invest in it.

You can potentially approach the owners of a private company about investing, but they’re not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of their shares to the public to be traded on a stock exchange. This is why an IPO is also referred to as “going public.”

Step 1: Finding an Underwriter (6 Months before the IPO)

Once the company feels that it has the management team, processes and controls and other items in place for the IPO, the next step is to select a group of investment banks, known as underwriters, to manage the IPO. This interview process is known in the industry as a “bake-off.” The company will interview several investment banks to determine which one will lead the IPO process, and which others will be part of the underwriting group. Investment banks that are commonly lead underwriters include:

Once the lead underwriter is selected, the company and the lead underwriter will select the other investment banks that will be part of the underwriting group. Being selected as the lead underwriter on an IPO is a big deal (both financially and for prestige), and investment banks compete ruthlessly to obtain these lead underwriter mandates.

Which banks are selected? That depends.

Some companies already have close relationships to companies like Morgan Stanley, Credit Suisse, Goldman Sachs, or others. One consideration is whether the bankers have an expertise in the space you are working in, such as biotech.

Another consideration is distribution. Most companies want as many investors as possible to own stock in the company. Some banks have broader distribution networks than others. Some have expertise in distributing stocks to institutions.

Big firms may seem like obvious choices, but smaller regional or investment boutiques may have relationships with very specific investors that may be a better fit.

One thing’s for sure: A company with a strong business will have many bankers competing for their very lucrative deal.

How lucrative? For a small IPO (about $100 million) it could be as high as 6 to 7 percent of the float. Generally the bigger the IPO, the smaller the fee, so a bigger, higher quality IPO would typically get charged 3 to 5 percent.

Step 2: The Kick-off Meeting (4 Months Before IPO)

Once the underwriting group is selected, a “kickoff meeting” or “organizational meeting” is held. In attendance at this meeting are the company’s senior management, the underwriters and the lawyers. Discussed at the meeting include topics such as the IPO process, the timeline for the process, roles and responsibilities, and legal and accounting matters.

The kick-off meeting is usually followed by a series of due diligence meetings. This includes commercial, legal and financial inquiries, through which the parties working on the IPO gain a detailed understanding of the business of the company. This enables them to ascertain that nothing is wrong with the business and to establish its reality and sustainability, and that the company and its management are actually ready for life as a publicly listed venture.

Such understanding of the business is also necessary for a comprehensive listing document summarizing all the information required by investors to make an informed decision about investing in the shares of the company, and pursuant to the listing rules, to be drafted.

Step 3: Drafting Sessions and Filing the SEC Registration Statement (3 Months Before IPO)

Once the team of bankers (there could be more than one used, and usually is), lawyers, and accountants are decided upon, the banker will begin drafting an S-1 document.

This is the registration form required by the Securities and Exchange Commission (SEC). It’s the legal document that tells the world about the company’s plans for its proceeds, its business model, the competition, and its corporate governance, risks, and executive compensation.

Why does the company need to disclose so much information? The SEC wants as much transparency as possible to make sure investors have enough information to make intelligent investment decisions.

The document is then submitted to the SEC for their review. In the past, this filing was public, as well as any updates. Many companies were uncomfortable with this, because they were required to disclose detailed information to everyone — including their competitors — even if they ultimately decided to call off the IPO.

The SEC reviews the documents and provides comments. After the company receives the SEC’s comments, the registration statement is amended and filed with the SEC. This process repeats until the SEC is satisfied.

While the SEC is reviewing the documents, the company prepares for its road show, which is a series of marketing meetings with institutional investors who may buy shares in the IPO. The road show preparation includes creating a road show PowerPoint presentation, a video presentation (which is offered online to institutional and high net worth individual investors, underwriter sales force IPO summary (used by the underwriters’ sales forces to generate interest in the company’s stock once it is trading on an exchange), and practicing the presentations with company’s management.

The company will also decide which exchange (the NYSE or Nasdaq) the company’s shares will trade on once the IPO is held. Each exchange has certain criteria which must be met to list on the exchange, such as revenues, assets, etc. The company files an application with the exchange to have its shares listed on the exchange.

Now, thanks to new legislation called the JOBS act, most companies (except the largest) can file confidentially.

There may be several “amendments” to the filing as the company updates financial information and adds additional details, such as what stock exchange they plan to list on.

Once the SEC approves the document, and they are satisfied there have been sufficient information and disclosures, the company can file a “public” S-1.

Step 4: The Road Show: 2–3 weeks before the IPO

Once the SEC has provided its comments and the company’s registration statements is complete (other than pricing information), the investment banks have completed their due diligence and received their internal committee approvals, the company will go on a road show. These road shows take about two weeks, and the lead investment bank takes the company’s management around the country (and select foreign cities such as London) to meet with institutional investors to generate interest for the IPO.

During this process, a group within the lead investment bank, called the capital markets group, will call the institutional investors after their meetings to gauge their interest in buying the company’s stock in the IPO. The capital markets group will keep a running tab of potential investors, how many shares they are willing to purchase in the IPO, and what price per share they are willing to pay. Through this process, the capital markets group builds an “order book”, and using this information, the investment bank and the company can decide how many shares to issue at what price.

The company then launches a “road show,” a tour to meet investors, which can occur 21 days after the public S-1 is filed. At the start of the road show, terms for the IPO are announced. The company will say they are seeking to sell, say, 10 million shares between $18 and $20.

How do they determine the price and size? Typically bankers will look at several metrics, including the present value of a company’s cash flow, the value of the company in relation to sales or cash flow, or the value of comparable competitors who are already publicly traded.

Step 5: Pricing the IPO

When the company, the investment banks and the institutional investors have all agreed on a price and total number of shares, and the SEC gives its the IPO the go-ahead, the IPO is priced and sold.

The mechanics are complicated, but effectively an IPO is a three-step process: first, the shares are sold to the underwriters; second, the underwriters instantly sell the shares to the institutional investors who put in orders during the road show and a select group of other investors; and third, the shares start trading on the exchange.

Because of this complicated process, the IPO price (which is the price the shares are sold to the institutional investors) is different from the price of the first trade on an exchange. For example, Dropbox, Inc. priced its IPO (and sold shares to institutional investors) at $21.00 per share on March 21, 2018. Dropbox shares started trading on March 23, 2018 and the opening trade was $29.00.

Step 6: Trading

The IPO is typically priced the night before it starts trading on an exchange. The pricing builds in an “IPO discount” of around 15% as an incentive for the institutional investors to buy this risky stock. Since everyone knows about this built-in discount, it is expected that the stock will start trading at a premium to the IPO price.

This increase from the IPO price to the initial trade is called the “IPO pop” or “price pop.” Using the Dropbox example, it priced its IPO at $21.00 and the first trade was at $29.00 representing a 38% jump in price from pricing to the initial trade.

At this point, the company is now a publicly traded company.

The opening price is chosen so that supply and demand are balanced as well as possible. In other words, the opening price is the price that maximizes the number of trades that can be executed, based on all of the orders submitted thus far. This process is called price discovery, and is handled by humans at the NYSE (unlike Nasdaq, which handles price discovery electronically).

Once the opening price is decided upon, the Designated Market Maker (DMM) “freezes the book”, or blocks any new orders from coming in. Next, the DMM enters all of the accepted orders into the system, matching buyers and sellers based on the prices and sizes they submitted. The process of price discovery usually takes around fifteen minutes for the NYSE, but since Twitter is such a high profile stock with a great deal of anticipation and demand, the process takes over an hour.

The NYSE is unique in the sense that IPOs are still done using a modified open outcry technique. The market maker will evaluate the orders on his screen as they come in, and then occasionally turn and yell to the assembled traders the rough estimate of the demand and price for the stock.

it takes a stock about 11 minutes, on average, to find its correct price and start to trade though NYSE’s method — though consumer brands and tech deals typically take a bit longer because of increased interest from retail investors.

The role of stabilization

Once the IPO shares are free to trade the investment bank must play a supporting role. If shares trade up then the bank has the option to increase the offering by 15% at the IPO price to dampen the rise. In Twitter’s case this option represents another 10.5 million shares. The bank earns its commission on these shares and the company benefits from more proceeds.

This option is typically referred to as the “Green Shoe.” The term comes from the first company, the Green Shoe Manufacturing (now called Stride Rite Corporation), to permit underwriters to use this practice in an offering. The Green Shoe, or just “Shoe,” is exercised in the vast majority of IPOs. If the stock begins to trade down then the managing underwriter is expected to use its own capital to jump in and buy shares to “stabilize” the price.

The increase in demand from this stabilization buying sometimes succeeds in driving the price back up. The Shoe is available to the investment bank for up to 30 days and rewards the bank for taking the stabilization risk.

Step 7: IPO Research (25–40 Day After IPO)

Investment banks who are part of the underwriting team cannot publish research until 25 days after the company goes public; 40 days in the case of big companies like Alibaba. However, investment firms that are not part of the underwriting process can publish research at any time.

Step 8: Lock-Up Period Expiration

Employees and accredited investors typically do not get to sell their shares until the underwriters’ lockup is released 180 days after the close of the offering.