What is an Initial Public Offering (IPO)?

An Initial Public Offering, or IPO, is when a company seeks to list its stocks/shares on a public stock exchange.

How do IPOs work? 

Companies can use an IPO to raise initial funds for a new project, or to access additional capital for expansion, growth, or to pay down debt.

According to Financial Planner Dr Jeremy Britton, IPOs can prompt wider brand recognition, meaning companies can benefit from casting a wider net for investors.

“A company can use stock and/or stock options to reward and retain key employees. Additional stock buy-in can provide liquidity or an exit strategy for early investors or founders.”

Why go public?

Going public via an IPO means you can raise capital quickly by reaching numerous investors, which you can then use to further your business.

For new companies, IPOs provide an opportunity to generate publicity by issuing shares, not to mention the prestige of being listed on a major stock exchange.

Companies can also use the lure of stock options to attract high quality employees to their business.

Underwriters and the IPO process

The IPO process requires an underwriter, an intermediary who facilitates the sale of stocks and guarantees a minimum price and/or a minimum number of stocks sold to ensure a successful launch.

Dr Britton says while the IPO process can be a complex one, the following basic steps must be followed. These include:

  • Appointing advisers 
  • Preparatory work 
  • Commencing institutional marketing
  • Lodging prospectus with the governing body (ASIC in Australia)
  • Processing of listing application by governing body
  • Marketing and offer period, which may include roadshow or tour
  • Closing the offer

Corporate finance advantages

A company may find it advantageous to withhold profits or reinvest into research and development, says Dr Britton.

“Having the option to decide whether to pay investors a dividend of 4%, 1%, or 0%, gives companies more options than they have with other forms of capital raising.”

Other advantages include:

  • Access to investment from the entire investing public to raise capital
  • Easier acquisition deals 
  • Improved credit borrowing terms than a private company
  • Lower cost of capital for equity and debt

Corporate finance disadvantages and alternatives

Of course, there are some disadvantages to consider as well, such as:

  • High expense of establishment and maintenance 
  • Requirement to disclose financial, accounting, tax, and other business information
  • Legal, accounting, and marketing costs are high
  • High level management required for reporting
  • Loss of control and agency problems resulting from new shareholders
  • Increased risk of legal or regulatory issues
  • Employee retention difficulties due to rigid leadership and governance by the board of directors. 

Alternatives include remaining private. Companies can also solicit bids for a buyout or explore other alternatives. 

Direct listing

Also known as Direct Public Offerings, direct listings do not require a company to work with an investment bank to underwrite the issuing of stock. 

Although this provides a company with a quicker, less expensive way to raise capital, the opening stock price will be subject to market demand and potential market swings. 

Dutch auctions

A Dutch Auction involves the stock price being lowered until it has enough buyers to purchase all the available stock.

“For example, ten investors may wish to purchase at $1, thirty may wish to purchase at $0.75, while 200 investors may be happy to pay $0.50, and 1000 may seek stock at $0.30.

“Depending on the number of available stock, supply may be used up before the lower limit is reached, so the sale price for all investor may be determined to be between $0.50 and $0.75.”

Investing in IPOs

Like many investments, investing in IPOs involves risk.

“Not all IPOs are successful, and not all rise,” says Dr Britton.

“Some IPOs have failed spectacularly, and some have gone from strength to strength. The IPO prospectus should provide the majority of the information which you will need to make a decision, but it does not contain a crystal ball.”

IPO performance

IPO returns are affected by many factors, just some of which include:

  • market factors, such as low/high interest rates, low/high unemployment, international exchange rates, etc.
  • industry factors which affect only a section of the economy, for example, airlines post-9/11 or post-Covid19
  • personal factors such as brand awareness or consumer comfort.

Key considerations for IPO performance

“Valuing a company is a complex process,” says Dr Britton.

“If it were simple, there would not be fluctuations and volatility in markets.

“It may be easier to value a company based on existing earnings, less easy to value on intangibles such as goodwill or brand awareness, and almost impossible to value on forecast future earnings.”

Lock-ups, waiting periods and flipping

Also known as ‘vesting’ or ‘golden handcuffs’, lock ups refer to those who buy in, or are given stock, and may be unable to sell them for a year or more, as part of the agreement.

“This can help to prevent temporary price dips after the IPO, as sellers will not outweigh buyers,” says Dr Britton.

Flipping is when you invest into an IPO and quickly exit, which some retail investors or institutions may be able to do.

“For some IPOs, where you have calculated the sale price as below the stock valuation, investors can make 30% or more in a single day on the launch.”

Tracking stocks

Most stocks can be tracked on the exchange on which they are traded.

You can also see them on other sites such as Yahoo Finance, stock broking sites, plus a variety of phone apps.

Long term IPO outlook

“IPOs have been a long-term tool for capital raising and will likely continue on stock exchanges for the foreseeable future,” says Dr Britton.

“In recent times, IPOs of stocks have been joined in the investment market by ICOs (Initial Coin Offerings) and ITOs (Initial Token Offerings) in the cryptocurrency market, as investors follow advances in blockchain technology.”

What makes an IPO a good investment?

There are as many tools for calculating value as there are economists, and valuations of IPOs or ICOs can be as subjective as valuations of artwork,” says Dr Britton.

“Anyone who is new to the investment space can pick up a book and learn the basics in a couple of hours.”

If you do want to delve in, it’s important to seek professional advice.