The Creation of IPOs

Many investors own or have owned shares in companies listed on stock markets, where they own a piece of the companies who have issued these stocks. When one buys and sells stocks on a stock market though, the companies that stockholders own a part of don’t get any of this money, no matter how high the price of the stock may rise.

Instead, these shares trade on the secondary market, and secondary here means secondary to the issuer of the stock having any involvement in the trading of its stocks. This is what the markets are for, to facilitate the trading of stocks and other financial instruments between investors.

So, when you purchase stock, on a stock market, you are buying it from another investor, and when you sell it, you are also selling to other investors. These investors may be large or small, but they are all trading in the stock for some financial purpose, usually to seek capital gains from it.

The Creation of IPOsIn order for any of this to be possible, these stocks must first be placed in the market in the first place. This is where the initial public offering, or IPO, comes into being. Companies may place further stock in the market as they evolve, but a stock must be listed and placed initially before any trading between investors can occur.

In order for stock to be sold, it must be priced, and if companies offered all of the stock that it has for sale during an initial public offering one morning at the opening bell, the supply would greatly exceed the demand at this certain point in time and the money received by the company for the stock would probably be considerably less than if this sale was performed in a much more organized manner.

Ultimately, as the demand for the stock caught up so to speak from the massive initial supply, the price would settle in to what the market feels is fair value for the stock, however the company issuing it only gets the initial sale price for it. The risk in just throwing it all out there in the market is that the sale of it would not proceed in the orderly fashion that the company desires, and this would be pretty much left up to the mercy of the market at the time of placement.

There is a reason why large institutions place their orders to sell, and to buy as well, over time, and it sometimes takes weeks for a very large order to be placed in the market. The reason that they take their time is that if not, the order would flood the market and this would drive the price down considerably, as there are only so many orders at a given price in the market and they would have to go much deeper into the order book or even go beyond it to find enough demand at that point in time to complete the order.

How IPO Shares Are Placed in the Market

Instead of dumping these shares on the market, companies hire the services of investment banks to bring their shares to market. Often times, the order is so large that several investment banks become involved in a single IPO, to better manage its placement and to also spread the risk around.

The introduction of an IPO represents risks for both the company and the investment banks, as there may be literally billions of dollars on the line and therefore this all must be orchestrated carefully.

These deals are highly customized and represent a lot of potential profit for both the banks and the company, and in some cases the banks will guarantee a certain price per share to the company, which of course increases the risk to them.

Typically though, the biggest risk to the bank is to their reputation, and an investment bank can ill afford to have things perceived as going wrong, as this will affect their desirability to act as an agent in future IPO dealings.

Investment banks will therefore generally agree to a deal where they promise to make their best efforts to get the best price they can for the stock for the company while still doing so in an orderly manner. Time and money are both important criteria, as they don’t want to delay the placement of the stock excessively, as the client, the company, will not be pleased to have to wait too long for their money.

Given the nature of securities regulation, there is a huge amount of red tape involved, with both regulators and the exchange that the company is seeking to be listed on. Regulators do tend to be overly cautious, although some of this goes back to the old days where it was common for tactics such as collusion and deception to take place, and the regulations seek to protect investors from being exposed to such tactics.

One of the drawbacks that companies perceive in going public is that they have to open their books to the public as well,  and public companies do undergo more scrutiny than private companies to be sure. This is usually seen as a price that is well worth paying though given the huge amount of money that IPOs can generate for companies,

Preparing to Get Your Stock to Market

The first step is arranging for the right deal with investment banks, who compete vigorously for these deals as we may expect, since they have the potential to be so profitable. The role of the investment banks is to act as an underwriter, which is required by regulators to approve the ultimate sale of the stock in question.

The reputation of the investment banks is added to whatever reputation the company may have, but the company relies on the underwriters for far more than this. Once a suitable deal is reached between the underwriter or underwriters and the company seeking to go public, the investment banks get to work, and there is much work to be done.

One of the big parts of this is coming up with what is termed a preliminary prospectus, also called a red herring. This is the document that is presented to regulators, the SEC for instance in the U.S. Even though this is just the preliminary prospectus, it can be hundreds of pages long.

The investment banks can make tens of millions from these deals, so they are certainly well compensated for, but they also do a lot of work here, and this is just the start of things.

Marketing the IPO

The real expertise here that the underwriter brings to the table is their ability to market the shares of the IPO. This includes setting an initial price, based upon what their expertise tells them should be set, although this is nowhere as easy as it may appear.

All of the shares that the company is seeking to place in the market may be offered initially, or some may be held back to issue later, hopefully at a higher price. There is a certain risk to both the company and the underwriters when this is done, but given that the price of IPOs so often rises after the issue of the initial shares, and sometimes quite dramatically, this can be a viable option.

If the offering doesn’t go so well though, this can result in these further shares bringing in less than they may have if they were offered as part of the initial allotment, so this option must be carefully considered before being agreed upon.

Since the underwriter wants to avoid just dumping the IPO shares on the market, which may even lead to disaster, they carefully place them with their clients initially, many of whom are very eager to get involved. This is due to the tendency for IPO shares to increase in value, although a lot of these shares are issued to institutional investors who may themselves look to distribute them to their clients.

IPOs are considered generally to be more desirable than stock on the secondary market though, mostly due to the fact that they are initially valued more in line with the value of the company than investors tend to.

Many Investors aren’t always primarily concerned with such things unless they are investing very long term, otherwise the potential for price appreciation by way of demand is seen as sufficient, which makes sense.

While the primary offering is usually limited to brokers and institutional investors, these shares are sometimes offered to the public initially, those with large enough accounts with the investment banks who are placing the shares may also be offered a piece of the action.

More modest sized but still fairly substantial investors may be able to buy these shares at their issue price from their brokers, who distribute a fair amount of them as a perk to drive client loyalty.

Once the shares hit the street so to speak, the market then takes over, and they become traded according to whatever the supply and demand is at any given time for the new issue. The underwriters still have a stake in things at this point though as they want to come across as not pricing the issue so low as it is obvious that they made a significant mistake.

It is fairly normal for the stock to trade higher than it normally would, although not all IPOs perform this way and may actually disappoint. There is a honeymoon period of sorts that IPOs go through, where the hype involved tends to overvalue them for a time, which often will settle down once those eager to trade in the IPO become satisfied.

While issuing initial public offerings almost always benefit companies, as well as underwriters, this is a process which requires both a lot of work and some careful analysis for things to go off the way all parties hope it will.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.