The IPO(or Initial Public Offering) is an extremely important stage for any company as it is the time beyond which the company will no longer remain private. There are multiple reasons why a company might want to go public - to finance its growth, to be able to buy companies with stocks, reputation, and visibility, a tool for management compensation, and it provides an exit opportunity for the founders.
Why a company goes Public?
We've already given an overview as to why a company might want to go public. The major reasons why IPOs are considered so important and why private companies after a few rounds of funding from credible VC and PE firms might wish to go public:
To meet the large CapEx requirement for the company for it's growth, expansion, and development
Avoid debt so that the company does not need to pay financial charges
To spread the risk amongst a large group of people - think of it this way. Whenever you buy a stock of any company, you are also buying some amount of risk associated with it. The risk might depend on the number of shares you're buying but essentially for those shares, you're taking the same amount of risk as the promoter himself.
Provide an exit opportunity for early investors
The Investors in an IPO
An IPO can be grouped into three categories - Retail investors, institutional investors, and hedge funds. Retail investors are private individuals looking to diversify their income to earn more money. They usually invest a lower amount. Institutional investors are entities like pension funds, mutual funds, and insurance companies. These entities have the resources and specialized knowledge to research a variety of investment options. Hedge funds are the investment vehicles that are interested in trading with underpriced and overpriced securities.
The primary goal of all three types of investors remains the same - they wish to invest in a company with good market leadership, strong management, and a solid financial position. They also seek liquidity in the secondary market where they can sell off their shares, if necessary.
IPO Sequence of Events
A typical IPO process lasts from 4 to 6 months. It usually has the following sequence of events:
Appointing an investment bank, in many cases, there are multiple investment banks involved in a single IPO
Applying to the regulatory body(SEBI in India/GAAP in the US) and getting a nod
DRHP - A document that gets circulated to the public with key information about the IPO like the estimated size of the IPO, the estimated number of shares being offered to the public, etc.
Market the IPO and coming up with the price band
Book building process
Closure and listing of the company on a stock exchange
Deciding the Share Price
The key goal of the IPO pricing mechanism is to provide a slight discount to the actual trading value of a company. The major techniques used to find how much the shares of the companies are worth include the Discounted Cash Flow Valuation(DCF) - from the historical records and business model, the Multiples Valuation - finding similar companies in terms of size, industry, market strategy, and geography.
After organizing various meetings with the investors, investment banks are able to come up with the number of shares the investors are willing to buy at a particular price. This process is called the Book Building process. At the end of all the roadshows, investment banks have a fair amount of idea of how many shares can be sold at different prices.
A Typical IPO Timetable
The IPO is an exhaustive process. It involves a lot of documents to be prepared and hence, a lot of time is devoted to this before the actual listing day of the company. A few months before the listing, the initial steps involve hiring various advisors - financial advisors, legal advisors, tax advisors, and industry advisors to carry out the due diligence of the firm along with the investment banks. The investment banks work with the company's management team to prepare the initial valuation of the company. Then a lot of exhaustive and heavy documents are prepared to describe all the aspects of the company's business. This also helps the investors to know about the company's business model through descriptive documents.
A few months before the IPO, investment bankers along with the top management of the company starts the roadshows to meet with key investors and to win their support. After the roadshows and book-building process, investment banks get a fair idea about the number of shares and the price of the shares and they suggest the owners of the company regarding the same. The final step involves listing the company on a stock exchange.
Post-IPO Stabilization
After an IPO, the price of the newly issued shares may falter or be shaky in trading. This is usually the case as an IPO is a very exhaustive process. If the IPO is sold at a price that turns out to be too high, then the investors would be disappointed and many of them might consider abandoning the stock, creating an immediate selling pressure, which in turn would drive the price even lower. On the other hand, if the stock prices are very high, this means that the company wasn't valued properly and the founders left a significant amount of money.
So, in order to prevent such situations, investment banks make stabilization efforts, which consists of supporting the share price in such circumstances. Typically speaking, in case the price goes up, the bank exercises it's Greenshoe call option, buys the shares on the market, and gives back the shares to the issuing company. Whereas, if the price of the shares goes down, the bank would buy shares on the market thus creating a positive difference with respect to the price it paid initially and make a profit margin. This is how the investment banks stabilize the post-IPO price of the shares.
Very well described!