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IPO Basics: Explaining IPOs in Simple Terms, With Examples

Companies in the U.S. have generated more than $70 billion in IPOs thus far in 2020. All of which outdistances the total for 2019, is the busiest since 2014, and the second biggest haul since 2000.

IPOs are all the rage on Wall Street, with anticipated IPOs from some of the bigger names in tech such as:

  • Airbnb
  • Robinhood

Already this year, other anticipated IPOs include Snowflake, Palantir, Asana, Unity Software, and Lemonade have gone public to great fanfare and large sums raised.

Given all the activity, I thought it might be a great time to discuss IPO basics and lay out some of the steps behind a company going public.

Even Warren Buffett’s Berkshire Hathaway got into the game with his company’s recent investment in Snowflake.

Despite the hype, not all IPOs lead to success for companies and investors. A perfect example is the recent failure of WeWork, which failed to go public because of concerns regarding questionable accounting.

In today’s post, we will learn:

  • What is An IPO in Simple Terms?
  • What Are the Steps in the IPO Process?
  • How To Measure the Success of An IPO

Ok, let’s dive in and learn more about IPO basics.

What is an IPO in Simple Terms?

The easiest way to define an IPO or initial public offering is: owners sell pieces of a private business to the public as a new stock offering.

The initial public offering allows the company to raise funds from public investors.

The transition from private to public allows private investors to realize gains from their private company’s initial investments.

The reasons for a company to go from private to public are a few. The first and primary reason is to raise money. By selling shares on the open market, the company can raise funds to grow the company.

There are also benefits for early investors or founders to cash out of their initial investment in the company. The IPO process generally raises funds exceeding the monies the founders have put into the company and allows them to exit with a profit.

Another benefit to an IPO is the increased liquidity; as long as there is a demand for the shares, the company can raise money for any needs.

One of the bigger benefits is the prestige that accompanies a company becoming a public company. In the past, only companies that had strong fundamentals were able to file for an IPO. But the tech world has changed that option with the growth of the internet boom.

Now, smaller, less profitable companies can file for IPOs, with investors gobbling up the shares as a chance to get in on the action.

But, things are not always rosy. For example, once you become a public company, you answer to those shareholders. The pressure to constantly improve starts, and it is relentless.

In addition to those headaches comes the regulation and the need to file public documents. Those documents, required by the SEC, expose any and all warts to the public. All of which ramps up the stress involved in running a public company.

Those documents are the quarterly and annual reports, such as the 10-k and 10-q, along with a litany of other regulatory filings required for all public companies.

Once the IPO process is final, the company’s shares will now trade on the stock exchanges. There are steps to follow along the process, which we will move to next.

What Are the Steps in The IPO Process?

There are five main steps that a company follows to become public.

Before the IPO, the company typically has a small number of shareholders. Those shareholders typically include venture capitalists, angel investors, and high net worth individuals, and of course, early investors such as founders, friends, and family.

Once the company goes “public,” the company becomes a publicly listed company on a recognized stock exchange like the NYSE.

The process of going public is not a quick, overnight process. It can take from six months to a year to complete.

Here are the steps below to go public with an IPO:

  1. Select a bank
  2. Due diligence and filings
  3. Pricing
  4. Stabilization
  5. Transition

Ok, let’s explore each step a little more in-depth.

Select a Bank

The first step in the process of filing an IPO is to find an investment bank to help you with the process and provide underwriting services.

A company theoretically could offer its shares on its own, but that is unrealistic in most cases. An investment bank is required; it is the way that Wall Street operates.

Underwriting is the process of raising money by utilizing either debt or equity. Debt would come in the form of preferred shares, or bond offerings, and equity in the form of stock shares.

Try to think of investment banks as the middlemen between companies and the investors, or the public.

Some of the bigger players in the investment banking world are:

  • Goldman Sachs – the biggest
  • Merrill Lynch
  • Credit Suisse
  • Morgan Stanley

Also offering investment banking services are names such as JP Morgan, Wells Fargo, and Bank of America. Although these banks offer investment banking, it is on a lesser scale.

In the U.S., the primary player is Goldman Sachs, especially for the bigger IPOs, such as Snowflake recently.

Many of the choices of picking an investment bank include:

  • Reputation
  • Quality of research
  • Expertise in the industry
  • Distribution
  • Prior relationship

Once the company chooses the bank, we move on to step two.

Due diligence and filings

Next on the list is to look at the underwriting process. The underwriter or investment bank acts as a broker between the issuing company and the investing public. All of which helps the private company sell its initial shares.

Among the items up for discussion when the investment bank meets with the company, let’s call them Snowflake and our investment bank Goldman Sachs.

At the initial meeting, Goldman Sachs will discuss with Snowflake what kind of funds Snowflake needs to raise, what types of securities it wishes to list on the stock exchange. And any details surrounding the underwriting agreement that need agreement.

There are multiple ways to structure the underwriting deal.

For example, a firm commitment allows the underwriter (Goldman Sachs) to guarantee raising a certain amount by buying the whole offer and reselling the shares to the public.

Another option is the best efforts agreement, in which Goldman Sachs sells the shares of Snowflake, but Goldman doesn’t guarantee the amount raised by the sale.

Goldman Sachs might be nervous about carrying the whole load, and then they might take on a partner, such as Merrill Lynch. In this arrangement, referred to as a syndicate, Goldman would lead the syndicate, and Merrill would sell part of the issuing shares.

Once both parties agree to the above issues, we move on to the filing requirements.

Engagement Letter

The engagement typically includes a couple of items:

  • Reimbursement clause – this clause mandates that Snowflake must cover all out-of-pocket expenses incurred by Goldman Sachs, even if the IPO is canceled at any stage of the process.
  • Gross spread/underwriting discount – the gross spread is determined by subtracting the price that Goldman purchases the shares from the price it sells the shares.

Typically, the gross spread is 7% of the proceeds, but it is certainly up for negotiation. Keep in mind the gross spread is a fee that Goldman earns.

If there is syndication, the gross spread splits between Goldman and Merrill on the percentages agreed upon. Typically Goldman receives a larger cut as the leader, with Merrill receiving the balance.

For example, Goldman Sachs might get 60%, and Merrill Lynch receives the balance or 40%.

Letter of Intent

The letter intent focuses on a few things:

  • Goldman Sachs intent to begin an underwriting agreement with Snowflake
  • Snowflake’s commitment providing all necessary information and documentation to Goldman Sachs as it carries out its due diligence.
  • An agreement from Snowflake providing Goldman Sachs with an overallotment option.

Once Snowflake and Goldman Sachs agree to everything above, the underwriting agreement is in place. Once done with pricing for the securities of Snowflake, the agreement is contractually bound.

Registration document

The registration document is a catch-all for all the information regarding the IPO.

It includes all of the financial statements for Snowflake, management information, any insider holdings, possible legal problems Snowflake is facing, and the ticker symbol used by Snowflake once finishing the offering.

There are two parts to the registration document:

  • Prospectus – the document provided to any investor in the company which contains all the financial information.
  • Private filings – not necessarily a public document, but necessary for the SEC

The purpose of the registration is to ensure that all investors have all the possible information they might need to make an informed Snowflake investment.

The SEC then checks the document to ensure all its due diligence is undertaken and that Goldman discloses all required information.

Red Herring Document

Once completing the registration documents, Goldman will create a prospectus that contains all the information about Snowflake, minus the effective date of IPO, and offering price.

Once finished with the red herring document, Goldman and Snowflake will market the IPO to investors to create a buzz.

Sometimes companies such as Snowflake might go on roadshows to generate buzz about the IPO. These dog and pony shows might last for three to four weeks and help create word of mouth or hype about the upcoming IPO.

Pricing

The next step in the process is to decide upon the pricing of the IPO.

Once the IPO has the SEC onboard, Goldman and Snowflake decide on an effective date. The day before the effective date, Goldman and Snowflake decide the offer price, which is the price the initial shares will sell for on Wall Street, and the total number of shares sold at the offering.

The offering price is critical because this is the price at which Snowflake’s capital will be raising for itself.

Multiple factors decide the offering price:

  • The success of the marketing efforts or roadshows
  • Snowflakes goals for the raising of capital
  • State of the economy during the offering

IPOs, contrary to popular opinion, are underpriced to make sure public investors fully oversell the issue. They will do this even though Snowflake may not receive full value for their shares.

By undervaluing the IPO, the issuing companies or Snowflake expect the share price to rise during the offering. The undervaluing of the shares creates a demand for the shares, which helps drive up the IPO prices.

Another logic to this undervaluing of the shares is that it helps compensate investors for their risk for investing in Snowflake’s IPO.

It is good news when the company sells out of shares on the IPO; it helps create additional demand.

Stabilization

Once Snowflake’s IPO is brought to the market. Goldman Sachs helps stabilize the offering with analyst recommendations, after-market stabilization, and creating a market for Snowflake’s shares beyond the IPO.

Goldman helps stabilize Snowflake’s market by purchasing shares at the offering price or below it to create demand and keep the momentum going forward.

Transition to Market Competition

At the IPO’s conclusion, Snowflake transitions to market competition, starting 25 days after the IPO, considered a “quiet period,” mandated by the SEC.

During the quiet period, investors transition from the mandated disclosures and prospectus to focusing more on the market for information about Snowflake.

After 25 days’ end, Goldman Sachs can provide estimates regarding the earnings and valuations of Snowflake. In other words, Goldman can now function as an advisor to Snowflake once the IPO is final.

That’s it, the whole shebang. All of that process takes about six months to a year from beginning to end.

It is no doubt an exciting and stressful time for the issuing company or Snowflake. And once the process is complete, then the real work of being a public company starts, with all the ups and downs.

Measuring the Success of an IPO

There are several ways to measure the success of an IPO.

Market capitalization is one of those methods, otherwise known as market cap.

Most analysts consider an IPO successful if its market capitalization is equal to or greater than the market cap of competitors 30 days after the IPO.

If the market cap is below that level, then analysts will consider the IPO in question. In many cases, this causes the market to react poorly to the company, and the company’s price is bound to fall.

The other measure of an IPO’s success is the market price remaining within 20% of the offering price. In many cases, if the price falls below that barrier, it is considered a failure by analysts.

Some companies do great during the IPO, only to struggle shortly after the reality of what investors have bought becomes real. Suppose the company is struggling to be profitable, which is the case with many companies going public. And the path to profitability is unclear; the companies start to struggle not long after the IPO.

A great example of this is Snapchat, which opened up 44% during its IPO, rising to $24.48 a share that day, but soon fell in price; until recently it traded below its IPO offering price of $17 a share.

For comparison, Snowflake initially offered its IPO at $140 a share, but on the day of the offering, prices quickly grew before the market’s opening to $210. And upon close of the day, shares finished at $240 a share.

And over 30 days later, the shares still trade above the initial IPO price, and in fact, above the final price offering for the day is at $253.

Final Thoughts

Once companies decide to go public and start down the path to an IPO, the future remains unclear until the offering is complete.

But once a company goes public, they still have the option to return to private ownership at any point in their existence.

For example, Petsmart, which was a public company until 2012, when activist investors pushed the company to sell to private investors and remove itself from the stock market.

And more recently, Dunkin’ Donuts announced they were in preliminary discussions to sell to a private investment firm and would no longer trade on the public markets.

Despite the glamour surrounding IPOs, many of the companies that go public have never made a profit, and in many cases, won’t for many years. And in some cases, never will. Instead, the IPO becomes a way for a founder to exit the company with a nice, fat paycheck.

Those are more extreme cases, to be sure. But they highlight the risks associated with investing in start-ups or IPOs; despite the hoopla and hype surrounding them, they do not always end up well (as you can see in the video below).

IPOs are risky, despite the SEC’s best efforts to ensure all the information needed to make an informed investment are present.

The simple fact of the matter is most companies going public in today’s markets are unprofitable companies, and no one knows for sure if they will ever turn a profit. And that simple fact makes investing in IPOs risky, but they are exciting.

That is going to wrap up our discussion of IPO basics.

As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave