How Do IPOs Work

Many people know what an IPO is, but ask themselves how do IPOs work? Reading below will give you a basic understanding of how an IPO actually gets off the ground.

The Prospectus

Once a company has decided they have a marketable offering capable of raising the funding they are after, the first order of business is to prepare a prospectus. A prospectus is a lengthy, detailed document which, by law must accompany any direct company-to-consumer offering of an investment opportunity. The nicely printed booklets probably are best known to you as an accompaniment to a mutual fund sales pitch. The prospectus is a legal document that institutions and businesses use to describe the securities they are offering for participants and buyers. A prospectus commonly provides investors with material information such as a description of the company’s business, financial statements, biographies of officers and directors, detailed information about their compensation, any litigation that is taking place, a list of material properties and any other material information. In an IPO offering, a prospectus is distributed by underwriters or brokerages to potential investors.

Underwriting

Choosing an underwriter and coming to agreement with them is the next step when a company goes public. The main role of the underwriter is to get the stock on the street. They also provide considerable guidance to help meet exchange and security commission requirements, arrive at a correct “to market” price and number of shares to issue, and generally apply their experience to help guide a company through the new territory of going public. The underwriter actually takes over the management of the entire process.

The managing underwriters may underwrite the IPO on either a firm commitment or best efforts basis. In a firm commitment offering, the underwriters will purchase the shares at a discount (of usually 7%) and resell them for the full public offering price to institutional and individual investors. In contrast, a best efforts offering means that the underwriters are only committing their best efforts to sell the shares.

Most reputable investment banks will underwrite an IPO on a firm commitment basis

If an IPO is being underwritten on a best efforts basis, it should serve as a warning signal to both the company and its potential investors. After all, how enticing will a company’s shares appear if its investment bank is unwilling to shoulder the risk of holding the shares, especially when purchased at a discount?

To help distribute the shares, the managing underwriters may form a syndicate composed of other investment banks. This serves two purposes. First, the underwriters may expand the marketing of the company’s shares through other investment banks. Second, the managing underwriters may reduce their risks by allocating shares to other investment banks. The syndicate members may agree to participate by either purchasing and reselling the shares, or just marketing the shares to their institutional and individual clients.