What is an IPO? Initial public offerings explained

Over the years, we’ve seen some memorable initial public offerings made in the world of big money. From Facebook and Twitter to Google and Snapchat, giant firms have consistently chosen to go public in order to grow the business to an even bigger scale.

What is an IPO? Initial public offerings explained

If you want to see the shareholder’s world of stocks and investments flipped upside down on its head, all you have to do is take a look at the historic direct public listing made by Spotify back in April. The IPO attracted huge interest from startups and millennials fascinated by the fate of their favourite music streaming platform. But it’s hard to understand a direct listing when you don’t even know what an IPO is, or what it entails.

What is an IPO?

An initial public offering, or “going public” is when a private company offers shares of its stocks to the public. It’s called an initial offering because it’s the first time that the company owners offer up shares to general shareholders.

Of course, firms can have shareholders, but they’re often few and far between. These shareholders also aren’t subject to regulation from the Securities and Exchange Commission.

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The shares are listed on a national stock exchange, commonly the New York Stock Exchange or NASDAQ in the US and the London Stock Exchange in the UK. The whole process of going public can take around three to four months for the whole process to be completed.

Why does a company choose to go public?

The aim of an IPO is pretty simple. It’s a way for companies to raise funds and inject more cash into the business. The company – along with input from its new shareholders – chooses how it spends the money. Whether the firm spends the money through acquisitions or just reinvestment to make the business better, it’s all completely up to the company and often its newly-found shareholders.

The IPO process explainedwhat_is_an_ipo_1

The IPO process is a fairly lengthy one but it isn’t too complicated to understand.

To start with, a firm hires one or more investment banks to handle the whole IPO process, which will take them from the beginning right to the first day selling stocks on the exchange. This is called underwriting.

Some companies, like Spotify, bypass the traditional investment bank method and sells shares on their own. It’s a lot riskier than selling shares through the investment bank middleman, but it’s probably a route more firms will take after Spotify’s successful direct listing. We’ll get into this a bit later on.

When a company announces that it is going public, investment banks will send out bids to the company with predictions on how much money it will make and how much the bank will earn. It’s extremely competitive as the banks try and battle it out to offer the best bid. The company will decide on a bank using these bids.

Hiring more than one investment bank is a typical route to take as it allows banks to form a group. This allows the company to spread the funding between each bank, reducing the risk if anything goes wrong.

Once the bank or banks are hired, the bids will be discussed in further detail. This will include the discussion of the type of security on the investment and the underwriting agreement itself.

When the bank and the firm agree the underwriting, the investment bank or banks write up a registration document that gets sent to the FCC. The document will outline previous financial statements, previous legal issues, who already owns stocks and where exactly the company will use the money. The IPO document will be investigated to make sure that everything is accurate before the FCC agrees and the firm sets an IPO date.

How do banks find the company’s future investors?

When the FCC gives the underwriter and the company the all-clear, the underwriter will produce an extensive document, called a prospectus, detailing previous and current financial information.

Then, with this prospectus in hand, the investment bank will travel around on something called a road show, where it will try and convince big prospective investors to buy shares in the company.

If the investor agrees, the underwriter is legally allowed to offer shares to the investor at the price set before the company is officially listed on the stock exchange. This is a deal called IPO allocation.

The underwriter and the company decide on a stock price as the IPO date comes closer, it’s all dependent on what the market is like at the time and how successful the road show went.

How does a company choose its stock exchange?

The choice of a stock exchange is also fairly competitive, as often both the New York Stock Exchange and the NASDAQ want companies on their listings.  In short, the more prestigious companies that use your exchange, the more companies will want to be on it.

Like investment banks making bids to companies, exchanges make pitches to the banks. The underwriter picks the exchange. Most of the giant tech firms are listed on NASDAQ rather than the New York Stock Exchange, but there are also smaller firms on the exchange too.

The biggest difference between the two is that the New York Stock Exchange is an auction market, while the NASDAQ is a dealer market. In an auction market, the highest bid for a stock is matched with the lowest asking price. The NASDAQ is far quicker and money exchanges hands frequently. In dealer markets, selling and buying happens electronically through certain dealers. Companies often list on the NASDAQ if they want to grow the business.

How do the investment bank(s) make money?

Simple. The underwriters fund the IPO, and before the company is listed on the stock exchange, will buy out shares of the company before the shares are inevitably raised on the exchange.

What happens after an IPO?

After a company’s initial public offering, it will have to abide by regulations set out by the FCC. The regulations are extremely dense, but the company will essentially need to follow disclosure rules, report its financial status on a continuous basis and is required to hold shareholder meetings.

What is a direct listing?what_is_an_ipo_3

Early in 2018, Spotify filed to go public, but under something called a direct public listing, surprising many. Why? Well mainly because it’s not the conventional listing that big Wall Street investors are used to.

A direct public listing is an initial public listing that goes past the usual route of finding an investment bank and an underwriter. The reason companies usually opt for traditional IPOs over directly listing on an exchange is because they are able to set the offering price and can buy and sell shares to stop the volatility of increasing or decreasing prices.

However, a direct listing allows the public and general shareholders to set the price of shares rather than the underwriter.

Before the momentous direct listing, Spotify explained that this method allows the company to list without selling shares to the investment banks and provides equal access to both sellers and buyers. It’s also more transparent.

If a company lists directly, the chosen exchange will set a reference price. Buyers do not need to follow this reference price but it’s used as a guide for the initial public offering.

Spotify was in a unique position to list directly for two reasons. Firstly, it’s notoriety makes a road show unnecessary and secondly, it didn’t need to raise capital.

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