IPOs
What is an IPO?
Initial public offering (IPO) or stock market launch is a type of public offering in which shares of a company are sold to institutional investors[1] and usually also retail (individual) investors; an IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company. Initial public offerings can be used: to raise new equity capital for the company concerned; to monetize the investments of private shareholders such as company founders or private equity investors; and to enable easy trading of existing holdings or future capital raising by becoming publicly traded enterprises.
After the IPO, shares traded freely in the open market are known as the free float. Stock exchanges stipulate a minimum free float both in absolute terms (the total value as determined by the share price multiplied by the number of shares sold to the public) and as a proportion of the total share capital (i.e., the number of shares sold to the public divided by the total shares outstanding).
Although the IPO offers many benefits, there are also significant costs involved, chiefly those associated with the process such as banking and legal fees, and the ongoing requirement to disclose important and sometimes sensitive information.
Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertake an IPO with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide several services, including help with correctly assessing the value of shares (share price) and establishing a public market for shares (initial sale).
First-half 2018 IPO market roars back from lull
The initial public offering market rampaged in the first half to its highest volume in years and one of the busiest paces ever, according to Dealogic.
In 2018, 120 companies have raised $35.2B on U.S. exchanges, the firm says, taking advantage of strong markets and favorable conditions.
And that amount doesn't count Spotify (NYSE:SPOT), which went public through direct listing and so didn't raise money through the traditional process.
On average, companies going public this year are trading 22% above IPO price, and tech companies are 53% over IPO price.
Bankers expect the pace to stay hot in the second half, with the biggest listings coming out of China (including Tencent Music Entertainment Group (OTCPK:TCEHY), which should go public in the U.S. in one of the year's biggest).
Getting in on an initial public offering
If the goal of investing is to buy low and sell high, then getting in on an initial public offering — more commonly called an IPO — must be the ticket to riches. Buy a hot new stock at a discount and then sell it for a huge profit just hours or days later, right? Seems like a sure thing.
But for most individual investors, that dream of getting in on the IPO action will never be realized. And that’s not necessarily a bad thing. For every fairy-tale stock that takes off like a skyrocket following an IPO, there are cautionary tales of many more IPOs that post lackluster results. Some even crash and burn.
3 reasons you can’t join the IPO club
First, understand the process: When a company goes public and issues stock, it wants to raise capital and make shares available to the public. The IPO is underwritten by an investment bank, broker dealer or a group of broker-dealers. They buy the shares from the company and then distribute the shares to investors.
Reason No. 1: Big buyers easier to find. Selling a million shares to an institutional investor is much more efficient than finding 1,000 individuals to purchase shares.
But even big institutions often don’t get as much of the action as they would like because the initial public offering may be quite limited. Especially with a smaller IPO, nobody really gets 100 percent of their fill. In fact, no one gets more than 10 percent of their interest in the allocation. The brokers find a home for the largest pieces. If there is a lot of interest, the shares go very easily into the hands of institutional investors
Reason No. 2: One hand washes the other. Institutions that get to participate in the initial public offering often do a lot of business with the brokers underwriting the deal.
It’s stacked in favor of large asset managers, but it is a money game and everyone is in it to make a buck and that is where it goes — it goes to the best customers of those brokers,
Reason No. 3: Your broker perceives you as poor. Management, employees, friends and families of the company going public may be offered the chance to buy shares at the IPO price in addition to investment banks, hedge funds and institutions. High net worth clients may be rewarded with IPO shares from time to time as well.
If you have an account with the broker bringing the company public and happen to keep most of your vast fortune with that broker, you may be able to beg your way into a hot IPO.
Lucky to lose out
Once the stock is trading on the exchange, small-fry investors and big-time professionals have plenty of opportunity to buy shares. In fact, waiting for this opportunity can be a smaller investor’s best strategy when it comes to new public companies.
“So far this year, over 40 percent of the IPOs are trading below their IPO price. It may be smart for the individual investors to look at IPOs, but maybe they shouldn’t feel that they’re missing a whole lot,” says Shelton Smith.
In fact, investors may be lucky to lose out. Case in point: In 2005, Refco, a global clearinghouse for derivatives that served more than 200,000 customers, went public. Within months, it fell into bankruptcy. Three months later they have accounting fraud
How to buy new IPO stocks
New IPOs often have limited histories and their valuation can be somewhat mysterious. This is particularly true when a company is in a nascent industry, as dot-com companies were in the 1990s and social media companies are today.
To get some insight into how the company works and how the stock is valued, investors can look at the massive registration document required by the Securities and Exchange Commission for all new securities Known as Form S-1, or the Registration Statement Under the Securities Exchange Act of 1933, the offering document must contain specific information for investors, including financial information, the business model, risk factors and information about the industry. These documents can be found on the SEC’s website, and they are normally loaded with caveats and disclaimers.
Buying individual stocks requires a lot of homework, and they can be incredibly risky. Most individual investors should consider very new companies carefully, and experts recommend devoting no more than 2 percent of your portfolio to any one stock.
The Top Four Ways to SPOT A HOT IPO
Long-Term Growth Potential: When you invest in an IPO, you’re investing in the future growth of that company. So it stands to reason that if you jump on a company in the early stages of a significant, long-term growth cycle, you can scoop up handsome profits before the crowd catches on. Go for companies in markets that offer 10 years of growth potential.
Two Years of Profitability: Remember the old stock market adage, “Share prices follow earnings.” Most IPOs that fail after their stock market launch do so because they lack earnings. But if a company is growing the bottom line, the share price is likely to follow. Roughly 75% of IPOs during the dot-com days couldn’t make the “profitability” claim… and they ended up in the trash heap. So insist on at least one to two years of profitable operations, and you’re more likely to avoid stepping on an IPO landmine.
$50 Million-Plus in Annual Revenue: Just as share prices follow earnings, they also follow revenue, according to University of Florida research. The key question is whether or not a company had sales of $50 million in the year prior to going public. Those that did rose by an average of almost 40% over the following three years. The companies that weren’t above the $50-million threshold only posted a 5% return over the same period.
Age: Make sure a company has existed long enough and has demonstrated long-term viability by the time it hits the stock market. Why? Because the older and more established a company is when it goes public, the better its shares tend to perform. Such proven viability isn’t something you could say about most IPOs during the dot-com collapse. The average IPO back then hit the market at just four to five years of age.
Essentially, when you’re investing in IPOs, follow the same rules as you would for other stocks. Namely, that fundamentals ultimately drive share prices. So use the guidelines above. The stronger the fundamentals, the greater the profit potential.
In addition, look for companies that intend to use IPO money for upgrading or expanding the business, rather than just lining the pockets of the executives and preferred investors. This helps filter out the overly hyped, more-speculative offerings and, instead, places the focus on robust, long-term fundamentals.
The Right Time to IPO Your Company
It’s challenging to pinpoint the right time to go public, particularly in the current era where we’ve seen market volatility crop up suddenly and often without warning. While the right time is different for each company, there are a few common traits that IPO-ready companies share.
6 Signs a Company is Probably Ready to Go Public:
1. You Can Accurately Forecast Financial Performance
Accurate financial revenue and cost projections are a crucial component of a business strategy and play a key role in a company’s success, particularly as a public company with institutional shareholders. Missed projections can have a sizeable impact on a company’s valuation and ability to raise debt or raise equity capital again. Accordingly, developing accurate forecasting and budgeting functions while your company operates privately is an important step in proving the accuracy and consistency of your financial reporting to gain credibility with investors. You’ll be expected to share records of historical financial statements and forecasts during the IPO process. Your company’s underwriters could recommend a precise number of years for which you should have audited records.
2. You Have the Right Executive Team in Place
The team that has led your company through its rapid growth until this stage may need to adjust in order to lead the company once it’s public. Do you have public company experience in your C-suite? Are they the team to take growth to the next level? Planning your organizational structure in advance of going public can help add stability and efficiency when it comes time to expand and introduce new employees to the organization.
It’s important to think about your team structures, roles and responsibilities, and lines of reporting ahead of your IPO. For example, you’ll likely want to focus on increasing your accounting and finance staff, and possibly developing more of a focus on external communications. One particular area you may not have had to consider as a private company is your investor relations (IR) team. You’ll want to have an experienced investor relations officer or possibly an IR consultancy in place, along with a robust IR infrastructure that enables your company to effectively communicate with the market.
3. The Company Regularly Closes Its Books on Time and is Audit-Ready
You’ll want to be in a position to consistently close your quarterly financial statements on time prior to going public. Even companies backed by private equity and venture capital that provide regular reporting to their board and sponsors can find the extra rigor of preparing full financial statements challenging at the beginning. Going through this exercise in advance helps you prepare for public reporting obligations and may unearth needs for additional staff for reporting, internal controls or other areas related to financial planning and analysis.
As a regulated public company, you’ll be subject to regular accounting audits. To prepare, it’s a good idea to conduct a number of internal audits before your IPO. The auditor will review your financial records and internal controls to identify any potential issues and outline solutions.
4. You Have Realistic Valuation Expectations
When your company enters the public equity market, your valuation may be impacted by the price/earnings multiples of your publicly traded peers. Your financial sponsors and underwriters will evaluate the valuation environment to help you set realistic expectations. The market conditions at the time you IPO will have a bearing on what valuation level can be expected initially, and then your performance as a public company will help establish your valuation over the long term.
5. There’s a Compelling Business Case for Going Public
The obvious reason for going public is to gain access to capital markets and establish a currency for raising additional capital, conducting M&A and rewarding employees with equity-based incentive compensation. In addition, the capital raised through an IPO can be a critical source for funding research and development, new products, capital expenditures, acquisitions and ongoing operations. An IPO is seen as a major milestone in a company’s evolution, and becoming publicly traded is often seen as a strong indicator that your business is able to satisfy stringent compliance and governance standards. And of course, another incentive for taking your company public is to offer your early stakeholders liquidity and the chance to realize a return on the risk they took to invest in building and growing the business.
6. You Have a Clear, Strategic Roadmap
Your strategic roadmap is the blueprint for your company’s investment story. It explains your business in a compelling way while also providing a clear strategy and operating plan for growing the business to provide the investment returns that prospective shareholders expect from a public company operating in your sector. When you go public, your strategy will drive the investment case and articulate management’s vision for the future.
Key Considerations before Going Public
The process leading up to your IPO is extensive, but preparing early and thoroughly can make all the difference. For more in-depth information about going public, consult the NYSE IPO Guide, but a few initial considerations are below.
- Focus on governance – It’s typically best to start filling out your board 1.5 – 2 years before you plan to go public. As you’re building your board, keep in mind that you’ll want to include a diverse range of experts with executive and/or governance experience. Board requirements for public companies include having a majority of independent directors, implementing an audit committee that is made up of a minimum of three directors who meet financial literacy and independence standards, as well as having a committee of independent directors charged with compensation and corporate governance standards, among other requirements.
- Begin planning for financial reporting a year ahead – There’s a lot to accomplish as you prepare for public reporting. The IPO Guide has more in-depth considerations, but here are a few tips to remember: Begin by looking at your company historically with the intent of auditing and solving any existing issues. Next, look at your company’s current routine. Ensure your financial quarters close at standard times for public companies; if necessary, look at companies in your vertical to see when they’re reporting. And understand the expectations of analysts in your sector to ensure that you are prepared to report on the metrics investors use to understand your business.
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