Private Companies Going Public
When a company first offers its shares to the public, it is called an initial public offering, or IPO for short. Trading in IPO shares can present some good opportunities to individual investors if they are fortunate enough to get in early enough, but given the additional volatility that runs both ways, extra care must be exercised.
When a company’s shares trade on a stock exchange, this is called going public. Prior to that, companies are privately owned, meaning that their shares are held by only a few individuals, typically the company’s founders, employees, and private investors who have funded the company’s startup or expansions.
In order to invest in a private company, you would have to approach the company with the offer to invest or be solicited by them, so being able to purchase shares of the company on the open market, from other shareholders, is much easier. Privately held shares are difficult to sell since there’s no open market for them, so for shareholders, going public adds vastly to the liquidity of these shares, and private shareholders often sell a good portion of their stock in the market after the IPO.
So there are some big advantages to the shareholders to conduct an IPO, as well as to the business. IPOs raise a lot of cash from the sale of the newly issued stock, and this is the cheapest way that a company can raise capital.
In exchange for this, the existing shares become diluted, but this is generally seen as a good tradeoff. So if a company doubles the amount of shares it has issued, each share initially is only worth half its value, but the stock offering raises a lot of capital, and this extra capital makes the company worth more and each share worth more, so if this is done properly this part should pretty much even out, and in fact the plan is to have their shares worth more, and this is generally the case.
The Benefits and Drawbacks of Going Public
The real benefit to initial shareholders though is that their shares going forward will be now priced according to the demand they bring in the market, including those looking to speculate on the company, which can drive the price up quite a bit in itself, especially in the earlier stages of the IPO.
Provided that the company is well managed, meaning that they make good use of the new capital that is raised by the IPO, this should also spur further business growth and put them on track to have the value of their company increase over the long run. The fact that the capital raised does not cost the company very much at all adds to this benefit.
This is actually behind a lot of the interest that IPOs get from investors, and some of the stories that have unfolded from the more successful IPOs out there are legendary. Of course not all IPOs meet with this sort of success, and some aren’t really that successful at all, and of course some do flop, where investors may end up selling at a loss when it turns out that an IPO has been more hype than substance.
However, while there is a lot of hype here, and by design, as those handling the IPO go all out to create as much as they can, the injection of capital that IPOs provide, in addition to the increased demand for the shares that itself can drive the price up a lot, does make these stock offerings well worth considering for both companies and investors.
Companies typically reach a certain size prior to going public, although not all large corporations offer their shares to the public, and there are some pretty big ones that don’t. There are several issues that may be considered as drawbacks that companies carefully consider before they look to go public, and the term public here applies to not only its shares being opened up to the public, as a lot of their business activities become public as well.
Public companies are regulated much more strictly than private companies, and this places them under the scrutiny of both securities regulators and the stock exchange that they are listed on. Regulation is designed to protect investors, and part of this involves making public companies much more transparent, so that business activities and the health of the business can be more readily observed and monitored.
However, by exposing their business activities in such a way, in addition to the prestige involved in being listed on a stock exchange, the capital that offering shares to the public raises, and the much greater liquidity of their stock, there are other benefits that accrue from all this.
Public companies may qualify for lower interest rates as a result of this for instance, and the greater exposure itself may enhance their profitability. IPOs also open up the door to the acquisition of other companies, where they can issue stock in lieu of cash, and this happens a lot in acquisitions, making it easier for companies to expand.
There are significant costs involved in setting this up though. The biggest drawback is that principals of the company end up giving up at least a fair bit of control of the company to its new shareholders, provided that they no longer hold the majority of shares, which is typically the case.
How IPOs Come to be Created
In order to create an initial public offering, a company will hire an investment bank to execute the plan, called underwriting. This is either performed by a single investment bank, or commonly, by a consortium of investment banks working together to promote it. This serves to spread the risk around and makes it more likely that the offer will be accepted.
Banks either agree to purchase the initial shares themselves, to be sold to large investors, or provide their services on a best effort agreement, meaning that they will make their best efforts to raise as much capital for the firm as they can.
Provided that the company satisfies the requirements of the underwriters to take over the IPO, the details of the IPO become agreed on, and then the underwriter has an initial prospectus written up, called a red herring, and then conducts what is termed a road show to promote the IPO to large institutional investors.
The sale of an IPO is the only time that one buys shares directly from the company, as stock is traded on secondary markets, where you buy the stock from other shareholders and not the company. New stock offerings are generally only offered by investment banks to very large investors, although sometimes initial offerings can fall in the hands of individual investors as well, but only the larger and more active ones, who have accounts at the issuing financial institution.
Trading in IPO Stock
By the time that almost all individual investors get a chance to get in on an IPO, the stock is already being exchanged on the secondary market, the stock exchange, and while the demand present in the stock exchange will often create some nice gains over the issue price, a lot of this appreciation occurs in the very early stages of an IPO.
What you don’t want to do is be late to the party with this stock, after it has been run up, as many of the initial purchasers of the IPO may be looking to take profits before too long passes, especially after the initial momentum dies down.
Even though how long you plan on holding the stock, your time horizon in other words, dictates your strategy here, as it always does to some degree, it sometimes takes quite a while before a stock reaches its initial plateau again, and often can be bought more cheaply later, especially after the cooling off period expires and plays out.
Owners of the initial stock are prohibited from selling it for a certain amount of time after the IPO, anywhere from 3 months onward, depending on the terms of the IPO. This is to allow the IPO to better flourish during its early period, without the risk of huge amounts of stock being dumped on the market, as can happen when big shareholders look to get compensated by selling a lot of their original stock ownership.
This period does expire though and is something that investors need to be aware of, especially if they are looking to hold the IPO stock for an extended period of time, instead of just looking to realize short term gains driven by the initial momentum.
So in a sense, IPOs create a bit of a bubble, where the demand side is artificially high due to the constraints of the cooling off period, and once things have cooled, you can see a wave of excess supply, for a time anyway. Once this is all settled, then the true supply and demand will prevail and the stock will gain more stability.
So IPOs tend to be more exciting and often more lucrative than trading in more established stocks, this is due to the lack of stability in IPOs, especially in the early phase. So this does present some real opportunities for individual investors, provided that they really pick their spots with these and get in on the offering very early on, before it gets run up too much from all the excitement out there with these.