· What is an IPO?
An initial public offering (IPO) is the process through which a company makes
the transition from a privately held entity to a public company with stock
traded on one of the major stock exchanges. Typically, a company going through
an IPO is young and relatively unknown, therefore IPOs generally are considered
riskier investments. However, established private companies occasionally
decide to "go public" in order to raise more capital.
· The underwriter
The issuing company (i.e., the company going public) needs the assistance of an investment bank -- referred to
as the "underwriter" -- to price and market its stock offering. Banks compete
for the issuing company's business during a process known as the "beauty
contest" or "bake-off," in which they present their credentials to the company's
board of directors and assess a preliminary valuation of the company. If the
issuing company is new and relatively unknown, the banks often make valuations
based on the company's competitors.
The issuing company generally chooses an investment bank based on its underwriting experience,
particularly with IPOs in the same industry. Another consideration for the
issuing company is the credibility of the investment bank's research analyst, who issues reports on the company throughout the year.
The issuing company can give its business to more than one underwriter, in
which case the bank that manages the IPO becomes known as the "lead
underwriter," and the group of banks participating in the deal are called the
· The prospectus
The Securities Act of 1933 requires a
company intending to go public to file a legal document known as the "prospectus"
with the Securities and Exchange Commission (SEC).
The prospectus includes the company's financial history and growth strategy,
the details of its offering, and information on company management. It also
outlines industry competition and other risk factors that investors would want
to know in advance. In essence, the prospectus provides all of the information
investors need to know in order to decide whether to participate in the IPO.
The preliminary prospectus is also known as a "red herring" because of the red
ink used on the front page, which indicates that some information -- including
the price and size of the offering -- is subject to change.
· For more information on how to read a prospectus, see "A look at the
prospectus" by Darren Chervitz of CBS Marketwatch.
· The "road show"
An essential part of the issuing company's marketing campaign, the "road show" is
a multi-city tour during which the company pitches its business plan to
potential investors, usually institutional investors such as mutual funds,
endowments, or pension funds. At these meetings, the underwriter attempts to
gauge the level of interest in the IPO, which helps lead to a decision on how
to price the stock offering. Typical stops on the tour include New York, San
Francisco, Chicago, Los Angeles, and Boston. If the underwriter senses enough
international interest, a road show also may visit Europe and Asia. Following
the road show, the company prints its final prospectus, distributes it to
potential investors, and files it with the SEC.
· Pricing and allocating the IPO
During and after the road show, in a process known as "book-building," the lead
underwriter surveys potential investors and notes the interest in the stock so
it can price the IPO accordingly. The issuing company and the lead underwriter
meet to set the "offering price" and the number of shares to be issued at the
offering, based on the expected demand for the stock.
For the investment bank, the objective is to balance the company's desire to
price the stock so as to raise as much money as possible and the investors'
interest in gaining some financial reward for taking on the risk of investing
in a company with an unproven public track record. Each bank in the syndicate
receives a certain number of shares to allocate to its clients.
· The "pop" versus "money left on the table"
The "pop," also referred to as the first-day price spike, is the price differential between the offering price of an IPO stock and
its closing price on the first day of trading. During the dotcom bull market
of the late 1990s, with first-day gains reaching triple-digit percentages, the
pop unofficially became an important marketing or "branding" event for the issuing company.
The pop multiplied by the number of shares sold is known as the
"money left on the table" -- that is, money in the hands of investors rather
than in the issuing company's coffers. In order to balance the needs of the
investor and the issuing company the investment bank traditionally tries to
price a deal so that the first-day pop is about 15 percent. Thus, the issuing
company can raise substantial capital while investors are rewarded for
gambling on a riskier investment.
· "Flipping" the stock
The practice of an investor buying stock in an IPO at the offering price and
quickly selling it for a profit when it starts trading is known as "flipping."
Though it became common during the dotcom IPO frenzy of the late 1990s, this
practice is generally discouraged by underwriters, who are looking
for investors willing to make a long-term commitment to the company. Such anti-flipping policies, however, do not apply to large institutional clients of investment banks.
· The "quiet period"
The quiet period begins when a company files a preliminary prospectus with the
SEC and ends usually 25 days after the stock starts trading. During this period
the company is prohibited by the SEC from distributing any information about the company not
included in the prospectus.
· The "lockup period"
The lockup period is the period during which company insiders -- primarily management and venture-capital investors -- are prohibited
from selling their shares. U.S. law mandates that the lockup period last for
90 days after the stock is first publicly traded, although this period is often
extended to 180 days to satisfy potential investors.
· Can individuals invest in an IPO?
Underwriters typically allot IPO shares to their best clients, including hedge funds, large institutional investors, and some wealthy individuals. Therefore,
shares are difficult -- though not impossible -- for the average individual
investor to obtain. The best advice for an individual seeking to invest in IPOs
is to develop a relationship with a broker who can obtain IPO allocations for
his or her clients.
Online investment banks are another option for individual investors seeking IPO
shares. Several online investment banks, such as Soundview Technology Group
(formerly known as Wit Capital), E*Trade, or W. R Hambrecht & Co. offer IPO
shares directly to retail customers. Charles Schwab also offers IPO shares to
retail clients who meet certain eligibility requirements.
· For more, see "Getting a Piece of the Action," by the editors of CNN and
"Beginner's Guide to IPOs," Darren Chervitz, CBS
"Investing in IPOs,"
"Initial Public Offerings" (PDF)
Jay Ritter, University of Florida
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