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If you are interested in getting into the world of finance and stock trading, you may have come across the term initial public offeringbefore. But what does this even mean? Why do companies choose to do an initial public offering? In this article, we take a look at what an initial public offering even is, its advantages and limitations, and how it works. Make sure to keep reading to learn more about this interesting topic.
What is an IPO?
An initial public offering (IPO) refers to the process of a private company offering shares to the public for the first time. An IPO allows a soon-to-be public company to raise equity capital from public investors. This transition from a private to a public entity can be an important time. The company will decide how many shares it wants to offer, and an investment bank will suggest the initial price for the stocks based on their predicted demand.
How does an IPO work?
There is no doubt that going public is an incredibly challenging and time-consuming process. This means it is difficult for a majority of companies to navigate alone. A private company that is planning an IPO not only needs to prepare itself for a sudden increase in public scrutiny, but also has to file a lot of paperwork and financial disclosures in order to meet the requirements of the Securities and Exchange Commission (SEC). This is the organisation that oversees public companies.
When a private company is planning to go public, they usually hire an underwriter. The underwriter is often an investment bank, who will help them consult on the IPO and set the initial price of the offering. Underwriters generally help companies prepare for an IPO, as they create key documents for investors and schedule meetings with potential investors, otherwise called roadshows.
Once the company has set an initial price for the IPO, the underwriter will then issue shares to investors. Now, the company stocks will begin to trade on the public stock exchange, such as the NASDAQ, for example.
Why do an IPO?
An IPO will be the very first time the general public can purchase shares of a particular company. That said, it is important to understand that the general purpose of an IPO is to let early investors cash out any investments.
You can consider an IPO as the end of one stage in a company’s life cycle and the beginning of another. For instance, some investors may be looking to sell their shares in a new venture or startup. On the other hand, investors who are investing in more established private companies that are about to go public may also want to take advantage of the opportunity to sell some or all their shares.
There are a few other reasons why a company may pursue an IPO. These include raising capital or boosting a company’s public profile:
- Companies can raise more capital by selling shares to their public. These funds can be used to expand the business, pay for research and development, or pay off debt.
- Other ways of raising capital – for instance through venture capitalists, private investors or bank loans, may be too costly.
- Going public provides a huge amount of publicity – some of it free.
- Some companies may want the standing and reputation that comes with being a public company, which may also help them secure better terms from lenders in the futures.
That said, going public has its own set of complications. There are disclosure requirements, such as filing annual and quarterly reports. Public companies must also answer to shareholders, and report on the stock trading by senior executives, as well as the selling of any assets.
What is the IPO process?
The IPO process mainly consists of two parts. The first is the pre-marketing phase of the offering, while the second is the IPO itself. When a company is interested in an IPO, it will advertise to underwriters – either through private bids or making a public statement to generate interests.
The underwriter typically leads the IPO process, and they are chosen by the company. A company may choose one or several underwriters to manage different parts of the IPO process. The underwriters are involved in due diligence, document preparation, filing, marketing and issuance.
Advantages and Limitations to an IPO
The primary objective of an IPO is to raise a company’s capital. That said, it also comes with plenty of other advantages as well as limitations.
Advantages
A key advantage of an IPO is that the company gets access to investments from the entire investing public in order to raise capital. The makes it easier to gain acquisition deals, as well as increases the company’s exposure, public image and prestige. This can ultimately help the company’s sales and profits in the long run.
An IPO also comes with increased transparency especially with the required quarterly reporting. This can help companies receive more favourable credit borrowing terms when compared to a private company.
Limitations
However, there are several disadvantages to going public, which is why a few companies choose alternative strategies. Some major limitations include IPOs being very expensive. The cost of maintaining a public company tends to be ongoing and is typically unrelated to the other costs of running a business.
When a company’s share price fluctuates, it can also cause a distraction for management. Management may wind up compensated and evaluated based on stock performance rather than actual financial results. Additionally, the company also needs to disclose financial, accounting, tax and other business information. During these disclosures, businesses may have to reveal secrets and business methods that may potentially help competitors.
Public companies that have rigid leadership and governance by the board of directors can make it difficult to retain good managers that are willing to take risks. In the long run, this can cause a company to stagnate and fall behind its competitors.
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