An initial public offering is the first issuance of equity by a formerly private company to the general public. This usually takes place once a business has a history of profitability and sufficient future prospects to attract investors.
When the board of directors believes that a company is ready to make the step from being a private company to a public company, it hires a legal firm that specializes in SEC filings to complete a registration statement. This form is mandated by the SEC, and contains a detailed review of the company’s financial and operational condition, risk factors, and any other items that it believes investors should be aware of before they buy the company’s stock. The primary categories of information in a registration statement are:
- Summary information and risk factors
- Use of proceeds
- Description of the business
- Financial statements
- Management’s discussion and analysis of the business
- Compensation of key parties
- Related party transactions
There are a large number of additional categories of information, as well. As a result, the registration statement can be a massive document. Since the company’s auditors and attorneys must review it several times, and in great detail, it is also a very expensive document to create.
Once the SEC receives the form, its staff has 30 days in which to review the document – which it will, and in excruciating detail. The SEC’s in-house accountants and attorneys look for inconsistencies and errors in the registration statement, as well as unclear or overblown statements, and summarize these points in a comment letter, which it sends to the company.
The company responds to all of the SEC’s questions and updates its registration statement as well, and then sends back the documents via an amended filing for another review. The SEC is allowed 30 days for each iteration of its review process. The SEC staff is in absolutely no hurry to assist a company with its IPO; consequently, this question-and-answer process may require a number of iterations and more months than the management team would believe possible.
While the registration statement is being reviewed and revised, the company is also negotiating with one or more underwriters to assist the company in going public. The choice of which investment bank to use as an underwriter depends upon a number of factors, such as the prestige of the bank, whether it has prior experience in the company’s industry, the number of its contacts within the investor community, and its fee. A larger and more prestigious firm usually charges a higher fee, but also has a greater ability to sell the entire amount of a company’s offering of securities.
The company negotiates the terms of a letter of intent with its preferred underwriter. The following are among the key elements of the letter of intent:
- Fee. The primary fee of the underwriter is a percentage of the total amount of funds collected. In addition, there are a variety of legal, accounting, travel, and other costs that it may pass through to the company for reimbursement.
- Firm commitment or best efforts. The underwriter will either agree to a firm commitment or a best efforts arrangement. Under a firm commitment deal, the underwriter agrees to buy a certain number of shares from the company, irrespective of its ability to sell those shares to third parties. This is preferable if the company is targeting raising a certain amount of cash. Under a best efforts deal, the underwriter takes a commission on as many shares as it can sell.
- Overallotment. The underwriter may want the option to purchase additional shares from the company at a certain price within a set time period after the IPO date, which it can then sell to investors at a profit.
The underwriter supervises the creation of a road show presentation, in which the senior management team is expected to present a summary of the company and its investment prospects to prospective investors. These investors are likely to be mostly institutional investors. The bankers and management team will go through a number of iterations to polish the presentation.
The management team and its investment bank advisors embark on a road show, which spans several weeks and takes them to a number of cities to meet with investors. If investors are interested in buying the company’s stock, they tell the banks how many shares they want to buy, and at what price.
At this time, the company also files an application with the stock exchange on which it wants its stock to be listed. The stock exchange verifies that the company meets its listing requirements and then assigns it a ticker symbol. In addition, the company hires a stock transfer agent to handle the transfer of shares between parties. The company’s legal staff will also submit filings to the securities agencies of those states in which the company anticipates selling shares.
When the SEC is satisfied with the latest draft of the registration statement, it declares the filing to be “effective.” The management team and its bankers then decide upon the price at which the company will sell its shares. A key determinant is the price at which institutional investors are most likely to buy shares, since they usually comprise a large part of the initial block of shares sold. Underwriters want to set the initial share price slightly low, so that there is more likely to be a run-up in the first trading day that they can publicize. Also, a slightly low price makes it easier to create an active aftermarket in the stock, since other investors will be interested in obtaining and holding the stock to realize additional gains.
The company then sends the registration statement to a financial printer. The printer puts the final stock price in the document, and uploads it to the SEC.
The underwriter sells the shares to the investors that it has lined up. The underwriter collects cash from the investors, subtracts its commission, and pays the remaining proceeds to the company at a closing meeting. The underwriter is typically paid about five percent of the amount of the total placement, though this can involve a sliding scale where a larger placement results in an aggregate fee that is substantially lower. Conversely, bankers may not be interested in handling a smaller placement without charging a correspondingly higher fee.
The company is now listed on a stock exchange, has registered shares that are being traded among investors, and has presumably just received a large amount of cash for its efforts.