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An initial public offering (IPO) or stock market launch, is the first sale of stock by a company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises. Many companies that undertake an IPO also request the assistance of an investment banking firm acting in the capacity of an underwriter to help them correctly assess the value of their shares, that is, the share price (IPO Initial Public Offerings, 2011).
In 1602, the Dutch East India Company was the first company in the world to issue stocks and bonds in an initial public offering.[1]
When a company lists its securities on a public exchange, the money paid by investors for the newly issued shares goes directly to the company (in contrast to a later trade of shares on the exchange, where the money passes between investors). An IPO, therefore, allows a company to tap a wide pool of investors to provide itself with capital for future growth, repayment of debt or working capital. A company selling common shares is never required to repay the capital to investors.
Once a company is listed, it is able to issue additional common shares via a secondary offering, thereby again providing itself with capital for expansion without incurring any debt. This ability to quickly raise large amounts of capital from the market is a key reason many companies seek to go public.
There are several benefits to being a public company, namely:
- Bolstering and diversifying equity base
- Enabling cheaper access to capital
- Exposure, prestige and public image
- Attracting and retaining better management and employees through liquid equity participation
- Facilitating acquisitions
- Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.
There are several disadvantages to completing an initial public offering, namely:
- Significant legal, accounting and marketing costs
- Ongoing requirement to disclose financial and business information
- Meaningful time, effort and attention required of senior management
- Risk that required funding will not be raised
- Public dissemination of information which may be useful to competitors, suppliers and customers.
IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.
The sale (allocation and pricing) of shares in an IPO may take several forms. Common methods include:
A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold (called the gross spread). Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases.
Multinational IPOs may have many syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements and because it is an expensive process, IPOs typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and the white shoe firms of New York City.
Public offerings are sold to both institutional investors and retail clients of underwriters. A licensed securities salesperson ( Registered Representative in the USA and Canada ) selling shares of a public offering to his clients is paid a commission from their dealer rather than their client. In cases where the salesperson is the client's advisor it is notable that the financial incentives of the advisor and client are not aligned.
In the US sales can only be made through a final prospectus cleared by the Securities and Exchange Commission.
Investment dealers will often initiate research coverage on companies so their Corporate Finance departments and retail divisions can attract and market new issues.
The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe or overallotment option.
A venture capitalist named Bill Hambrecht has attempted to devise a method that can reduce the inefficient process. He devised a way to issue shares through a Dutch auction as an attempt to minimize the extreme underpricing that underwriters were nurturing. Underwriters, however, have not taken to this strategy very well which is understandable given that auctions are threatening large fees otherwise payable. Though not the first company to use Dutch auction, Google is one established company that went public through the use of auction. Google's share price rose 17% in its first day of trading despite the auction method. Brokers close to the IPO report that the underwriters actively discouraged institutional investors from buying to reduce demand and send the initial price down. The resulting low share price was then used to "illustrate" that auctions generally don't work.
Perception of IPOs can be controversial. For those who view a successful IPO to be one that raises as much money as possible, the IPO was a total failure. For those who view a successful IPO from the kind of investors that eventually gained from the underpricing, the IPO was a complete success. It's important to note that different sets of investors bid in auctions versus the open market—more institutions bid, fewer private individuals bid. Google may be a special case, however, as many individual investors bought the stock based on long-term valuation shortly after it launched its IPO, driving it beyond institutional valuation.
The underpricing of initial public offerings (IPO) has been well documented in different markets (Ibbotson, 1975; Ritter 1984; Levis, 1990; McGuinness, 1992; Drucker and Puri, 2007). While issuers always try to maximize their issue proceeds, the underpricing of IPOs has constituted a serious anomaly in the literature of financial economics. Many financial economists have developed different models to explain the underpricing of IPOs. Some of the models explained it as a consequence of deliberate underpricing by issuers or their agents. In general, smaller issues are observed to be underpriced more than large ones (Ritter, 1984; Ritter, 1991; Levis, 1990).
Historically, some of IPOs both globally and in the United States have been underpriced. The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it first becomes publicly traded. Through flipping, this can lead to significant gains for investors who have been allocated shares of the IPO at the offering price. However, underpricing an IPO results in "money left on the table"—lost capital that could have been raised for the company had the stock been offered at a higher price. One great example of all these factors at play was seen with theglobe.com IPO which helped fuel the IPO mania of the late 90's internet era. Underwritten by Bear Stearns on November 13, 1998, the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock. Although the company did raise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.
Underwriters, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the underwriters ("syndicate") arranging share purchase commitments from leading institutional investors.
On the other hand, some researchers (e.g. Geoffrey C., and C. Swift, 2009) believe that IPOs are not being under-priced deliberately by issuers and/or underwriters, but the price-rocketing phenomena on issuance days are due to investors' over-reaction (Friesen & Swift, 2009).
Some algorithms to determine underpricing: IPO Underpricing Algorithms
A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price (fixed price method) or the price is arrived at through the process of book building.
Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificates to the clearing agent bank's custodian, or a delivery versus payment (DVP) arrangement with the selling group brokerage firm.
Main article:
Quiet periodThere are two time windows commonly referred to as "quiet periods" during an IPO's history. The first and the one linked above is the period of time following the filing of the company's S-1 but before SEC staff declare the registration statement effective. During this time, issuers, company insiders, analysts, and other parties are legally restricted in their ability to discuss or promote the upcoming IPO (U.S. Securities and Exchange Commission, 2005).
The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO are restricted from issuing any earnings forecasts or research reports for the company. Regulatory changes enacted by the SEC as part of the Global Settlement enlarged the "quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over, generally the underwriters will initiate research coverage on the firm. Additionally, the NASDAQ and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-up agreement" for a securities offering.
Stag profit is a stock market term used to describe a situation before and immediately after a company's Initial public offering (or any new issue of shares). A stag is a party or individual who subscribes to the new issue expecting the price of the stock to rise immediately upon the start of trading. Thus, stag profit is the financial gain accumulated by the party or individual resulting from the value of the shares rising.
For example, one might expect a certain I.T. company to do particularly well and purchase a large volume of their stock or shares before flotation on the stock market. Once the price of the shares has risen to a satisfactory level the person will choose to sell their shares and make a stag profit.
- Agricultural Bank of China US$22.1 billion (2010)[2]
- Industrial and Commercial Bank of China US$21.9 billion (2006)[3]
- American International Assurance US$20.5 billion (2010)[4]
- Visa Inc. US$19.7 billion (2008)[5]
- General Motors US$18.15 billion (2010)[6]
- Facebook, Inc. US$16 billion (2012)[7]
The US last topped the IPO league tables in 2008; then east overtook west with China (Shanghai, Shenzhen and Hong Kong) raising $73 billion (almost double the amount of money raised on the New York Stock Exchange and Nasdaq combined) up to the end of November 2011. The Hong Kong Stock Exchange raised 30.9 billion in 2011 as the top course for the third year in a row, while New York raised 30.7 billion.[8]
- Gregoriou, Greg (2006). Initial Public Offerings (IPOs). Butterworth-Heineman, an imprint of Elsevier. ISBN 0-7506-7975-1. http://books.elsevier.com/finance/?isbn=0750679751.
- Goergen, M.; Khurshed, A.; Mudambi, R. (2007). "The Long-run Performance of UK IPOs: Can it be Predicted?". Managerial Finance 33 (6): 401–419. DOI:10.1108/03074350710748759.
- Loughran, T.; Ritter, J. R. (2004). "Why Has IPO Underpricing Changed Over Time?". Financial Management 33 (3): 5–37. http://bear.cba.ufl.edu/ritter/publ_papers/Why%20has%20IPO%20Underpricing%20Changed%20Over%20Time.pdf.
- Loughran, T.; Ritter, J. R. (2002). "Why Don't Issuers Get Upset About Leaving Money on the Table in IPOs?". Review of Financial Studies 15 (2): 413–443. DOI:10.1093/rfs/15.2.413.
- Khurshed, A.; Mudambi, R. (2002). "The Short Run Price Performance of Investment Trust IPOs on the UK Main Market". Applied Financial Economics 12 (10): 697–706. DOI:10.1080/09603100010025706.
- Bradley, D. J.; Jordan, B. D.; Ritter, J. R. (2003). "The Quiet Period Goes Out with a Bang". Journal of Finance 58 (1): 1–36. DOI:10.1111/1540-6261.00517.
- Goergen, M.; Khurshed, A.; Mudambi, R. (2006). "The Strategy of Going Public: How UK Firms Choose Their Listing Contracts". Journal of Business Finance and Accounting 33 (1&2): 306–328. SSRN 886408.
- Mudambi, R.; Treichel, M. Z. (2005). "Cash Crisis in Newly Public Internet-based Firms: An Empirical Analysis". Journal of Business Venturing 20 (4): 543–571. DOI:10.1016/j.jbusvent.2004.03.003.
- Drucker, Steven; Puri, M. (2007). "Banks in Capital Markets". In Eckbo, B. E.. Handbook of Corporate Finance. 1. Boston: Elsevier. ISBN 978-0-444-50898-0.
- "IPO Definitions". IPO Initial Public Offerings. http://www.ipoinitialpublicofferings.com/ipo-definitions.htm. Retrieved 14 September 2011.
- Mondo Visione web site: Chambers, Clem. "Who needs stock exchanges?" Exchanges Handbook. Published 2006-07-14. Accessed 21 September 2011
- Friesen, Geoffrey C.; Swift, Christopher (2009). "Overreaction in the thrift IPO aftermarket". Journal of Banking & Finance 33 (7): 1285–1298. DOI:10.1016/j.jbankfin.2009.01.002.
- Anderlini, Jamil (August 13, 2010). "AgBank IPO officially the world’s biggest". Financial Times. http://www.ft.com/cms/s/0/ff7d528c-a6bc-11df-8d1e-00144feabdc0.html?ftcamp=rss. Retrieved 2010-08-13.
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