Initial Public Offering

Initial Public Offering - Noordhoek Beach, Cape Town, South Africa
Initial Public Offering

An initial public offering (IPO, going public) is the first sale of a company’s common shares to stock market investors on a publicly traded stock exchange. An IPO permits a corporation to access a broad pool of investors, thus providing it with capital for future growth. On going public, the company is quoted (listed) on a stock exchange.

Listing imposes heavy reporting requirements and regulatory compliance. If the company later sells newly issued shares on the public stock exchange (again), this is then called a seasoned equity offering (SEO). The company offering its shares is known as the issuer.

The shares sold at the IPO can be either newly issued or existing shares. The money paid by investors for the newly issued shares goes directly to the company (in contrast to the sale of existing shares, where the money goes to the selling shareholders).

In practice, some IPOs consist entirely of newly created equity, with the original shareholders retaining all their shares; some IPOs involve selling only existing shares, with no new funds being raised for the company, but with the original owners selling some of their holdings.

Most IPOs consist of a combination of the two. The original investors will observe their shareholdings diluted as their percentage on the corporation decreases.

Hence, the two important functions of an IPO are providing finance to companies and providing an exit route for the original investors and entrepreneurs. Usually, certain shareholders (company executives, managers, employees, venture capitalists, etc.) agree to waive their right to sell (a part of or all) their existing shares for a certain predetermined time period following the offering (lockup).

IPOs usually involve one or more investment banks as underwriters who are responsible for selling the shares to the public. The syndicate of investment banks is presided by one or more major investment banks (lead underwriter).

The sale (i.e., the allocation and pricing) of shares in an IPO may take numerous forms, the most important being firm commitment and best efforts method. Under a firm commitment deal, the underwriters commit to selling all the shares offered.

If the offer is higher than the demand, the underwriters are left with the unsold shares. In a best efforts offering, the underwriters make no commitment other than to sell as many shares as they can; if they sell less than what is offered, the issuer receives a lower amount of money.

Upon selling the shares, the underwriter keeps a commission, which is usually based on a percentage of the value of the shares sold. The lead underwriters take the highest commissions—up to 8% in some cases.

The issuer typically permits the underwriters an option of enlarging the size of the offering by up to 15% under certain circumstances (greenshoe or overallotment option). Historically, IPOs have been underpriced, both in the United States and globally.