What Is Initial Public Offering (IPO) And How Does It Work?
We have all heard the term Initial Public Offering or its more common abbreviation of ‘IPO’ but what does it mean and how does an IPO work?
Let’s find out by taking a look at what an IPO is and how it works, and the process private companies need to go through to attain this status. There will also be a section on some significant pros and cons for private company owners to be aware of before committing to an IPO.
What is an IPO?
An IPO is the process of offering private company shares to the public for the first time in a new stock issuance. This is a time of transition because going through an IPO means that the private ownership of a company turns into public ownership. Due to this transition, the IPO process is often referred to as “going public”.
Progressing from a private company to a public company is a very important time for private investors. This is because it can help them fully realize gains from their initial (and any subsequent) investment through a typically included share premium.
On top of this, it also creates and gives access to a whole new public investment opportunity. One that is open to any investor wishing to participate.
Why do Companies Issue an IPO?
There are a wide number of reasons why a private company decides to go public. Major contributors to this include:
- It allows the company to raise equity capital from public investors.
- To raise sufficient capital to reduce or pay off debts.
- To fund growth initiatives.
- Increase public awareness by raising their company profile.
- To allow senior company figures to diversify their holdings or to create liquidity. This is achieved by selling a portion (or all) of their private shares as part of the IPO process.
While the above factors and more are solid reasons for going public it should be noted that it may not be the right move for every company. As will be seen later in the piece, there are advantages and disadvantages to deciding to go public.
The IPO Process is…
Essentially a two-part process with many elements involved in each. First, there is a pre-marketing phase of the offering. Second, comes the IPO itself.
A company interested in going public will either advertise the fact to chosen underwriters through the solicitation of bids or make a public statement to generate interest.
The company then chooses the underwriters who will lead the IPO process. It is at the discretion of the private company as to whether they choose one underwriting firm or opt for several different underwriters to be involved in the process. If the latter option is taken then several different underwriters will work collaboratively while managing different parts of the IPO process.
The underwriters concerned have a big role to play. Their involvement covers every aspect of the process. This includes such things as due diligence, the preparation of all documentation, relevant filings, necessary marketing, and finally, issuance.
A Walk Through the Steps to an IPO
While the process may differ depending upon the region the private company is registered in, it will help to break down the major steps required to go through what is seen as the common IPO process. These details are necessarily brief as there is an awful lot involved. However, these steps should indicate what is required:
Underwriter's proposals: Once a private firm invites selected underwriters to assist with their IPO the said underwriters will present proposals and valuations that outline their services.
In this documentation, there will be details of such things as the best type of security to issue, an offering price, the number of shares to be made available, and time frame estimates for the market offering to come to fruition.
Chosen underwriter: Once the company chooses its preferred underwriters they come to a formal agreement on the underwriting terms. This is completed through an underwriting agreement.
Team formation: It is then time to form the IPO team. These teams will consist of underwriters, lawyers, CPAs (Certified Public Accountants), and other relevant IPO professionals.
Documentation: Comprehensive company documentation needs compiling. The required documentation will vary depending upon the region of the world you are registered in and this will be the responsibility of the chosen team to complete and produce. This documentation will be revised throughout the pre-IPO process as will the included prospectus.
Marketing & Updates: There is a need to create pre-marketing materials for the new stock issuance. These materials are then distributed by the underwriters and executives involved to estimate demand. This part of the process intends to establish a final price offering. It is common for revisions of financial analysis to be carried out throughout the marketing process.
Board and Processes: A board of directors is formed to make sure quarterly processes for reporting the necessary auditable financial and accounting information are published.
Issuance of shares: On the set IPO date the company issues its shares. The capital from the primary issuance to shareholders is received as cash. This is recorded on the company’s balance sheet as stockholders’ equity. From there, the balance sheet share value is dependent upon the stockholders’ equity per share valuation.
Possible post-IPO provisions: Some post-IPO provisions may be put in place. If so, it means underwriters will have a specified period in which to buy additional amounts of shares after the IPO date. It is also possible that certain investors may be subjected to what is known as quiet periods.
The Pros and Cons of an IPO
Whether or not to move from being a privately owned company to a publicly owned company needs very careful consideration. For some founders, it is exactly what they have been aiming for since the beginning of their startup venture. For others, it is exactly the opposite.
While every situation is different it is important to weigh up the possible advantages as well as the potential disadvantages of going through the IPO process.
These pros and cons along with other business factors and personal goals need careful consideration before a decision is made.
The Advantages of an IPO
Let’s start with five commonly accepted advantages that going public can bring to a private company.
There is no doubt that the most often stated advantage of an IPO is money. In some quarters this makes it fully justifiable without even looking at other benefits. This is because the potential of a huge capital injection can benefit a growing company in a host of ways.
Newly-minted public companies can use these additional funds to finance R&D, fund capital expenditure, reduce their debt, hire new employees, or acquire new technology or other companies. Because a successful IPO brings in significant sums of funding it can transform the company’s growth trajectory to exciting new levels.
This is a benefit that cannot be denied and is particular to founders, early employees, and early-stage investors. It is these people who have contributed vast amounts of time, effort, resources, and funds to build a successful company.
Another factor comes with the knowledge that both founders and investors are very likely to have gone years without seeing any significant financial return for the contributions they have given.
For these stakeholders, an IPO is a significant exit opportunity. One that can see them potentially receive a huge amount of money or at the very least, allow them to liquefy the capital they have currently staked in the company.
Raising public awareness and market credibility
When going public this gives far greater exposure to the company. This exposure comes from the media and financial arena while going through the IPO. From there, news spreads and creates a far greater public awareness which in turn gives access to a much larger target audience.
As this exposure grows, a well-run and respected company will gain industry sector and customer trust. However, as will be seen below in the potential disadvantages of going public, the newly created public company needs to maintain investor, customer, and industry credibility.
Reduced cost of capital
The cost of capital is often a major challenge for any company. This is particularly the case for private companies because they often have to pay higher interest rates on any loans given or surrender a percentage of ownership when receiving investor funds.
Achieving IPO status means the company in question will have been through stringent financial and auditing processes. That in turn can help secure additional capital at lower interest rates and on easier terms.
It also gives public companies the ability to raise additional capital via subsequent public stock offerings. That is generally easier than having to raise capital via a private funding round.
Using stock as a means of payment
While it is possible, and generally seen as an attractive option to use private stock as a form of payment for key employees, this is seen as a longer-term reward because its real value is only seen once a favorable exit arises.
As for the public stock, this can also be used as a benefit and a form of payment to employees. Public stock awards are often viewed as a ‘currency’ that can be sold or bought at any time.
Offering stock awards to secure key employee positions to help your company grow is an attractive proposition for many.
Disadvantages of an IPO
Any private company considering an IPO needs a balanced view. To help with that thought process, here are some potential disadvantages of going down the IPO route:
Transaction costs and significant regulatory requirements/disclosures
Make no mistake, going through the IPO process is very expensive. There are hefty initial fees to be paid and from there, recurring external services are to be paid for.
Many view these costs as an inevitable part of the process and state that such huge costs are covered through the money made from a successful IPO. However, it really does depend upon exactly how successful the IPO is as to what profit is left once all other costs have been settled.
On top of these substantial costs, going public means the company is subject to far more regulations and disclosures than a private company.
Notably the regular filing of financial statements that are subject to strict conditions. Public companies are also faced with far more stringent financial controls than private companies. They will also need to avail of outside services such as auditing firms.
This can be burdensome and requires time and qualified knowledge. All of these factors and many more have to be paid for. The fact that public firms have to bear these costs to ensure they are adhering to the rules and regulations in place means that it is a very expensive (and recurring) part of a public company’s expenditure.
Market and external pressures
Founders and key employees of private firms are used to doing things their way and in a way they feel is best for their company. This means that a private company tends to take the longer-term view with a vision of where the company will be in years to come.
That is generally quite the opposite for a company that has recently turned from private to public ownership. Once in the public domain the company’s every move is scrutinized. It is also well-known that the stock market has a profit-driven, shorter-term view of performance.
This puts pressure on founders to perform and produce these short-term results for the public investors at large. Doing so can be detrimental to the longer-term vision of the company. Any founder who is against the constraints of short-term public goals should think long and hard before going public.
Founders' potential loss of control
This follows from the above point. Many founders see a potential loss of control in the business they have nurtured from the beginning as a major IPO disadvantage.
While ways to ensure that founders retain the ultimate decision-making power can be put in place things can change quite quickly. Going public means receiving public money and that in turn means the company leadership needs to keep the public happy.
This can lead to disagreement over what the leadership sees as the company’s stated direction against what public shareholders feel the company should be doing to act in their best interests.
If the majority of public shareholders feel the company is not functioning in a way that helps them make money they can force the company to appoint new leadership.
Seek Guidance on IPOs
If you are a founder in the early-stage thought process of whether to go public or remain private, professional advice should be sought. This can be a life-changing decision and as such you want to leverage the best possible terms and conditions for yourself and your company.
WOWS Global can help you achieve exactly that. We have our finger firmly on the private market pulse and are in a strong position to give advice and assistance on your individual status and how to maximize your company prospects.
The WOWS secure, online, digital ecosystem platform gives you every tool required to run your company in the best possible way. Taking advantage of our wide-ranging services and professional, knowledgeable advice will help to prepare startups at any stage of their life cycle for a possible IPO.
While that may be some way in the future, having a solid grounding and easy online data storage access for essential, sensitive company information is a must. WOWS can provide exactly that and from there will open up exclusive access to preferred, like-minded investors that are prepared to give funding that will help your company grow in a healthy and structured way.
The support and advice WOWS offers will help your company to flourish right through its private company journey.
Those founders wishing to find out more are invited to reach out to us for an initial no-obligation discussion on: