What is an IPO?
An Initial Public Offering (IPO) is the first offering of company stocks a private company makes to both institutional investors as well as retail investors. Post-IPO a company is no longer considered a private company and becomes a Public Limited Company. The process of going through an IPO and becoming a Public Limited Company also termed as ‘going public’.
Why ‘go public’?
The main advantage of a Public Limited Company is its ability to raise capital when required, especially if the company is listed on a recognized exchange. The capital these companies can raise is usually much higher than a Private Limited Company as their shares can be sold to the public for public investments into the company, this increases the number of investors they have. A Public Limited Company also has the advantage of being able to attract institutional investors through the exchange.
Spreading the Risk
As shares of a Public Limited Company are sold to the public this spreads the risk of ownership among a large number of shareholders. It also allows early investors to sell a portion of their shares in a company at a profit and still retain a considerable amount of ownership.
The requirements placed on a company when it becomes a Public Limited Company, improve its creditworthiness, this is good when it comes to issuing corporate debt as it reduces the returns a company needs to offer its investors.
The main purpose of raising capital is to deploy it in a manner to benefit the business. Access to a large pool of finance puts these companies in an advantageous position for:
- Pursuing new projects and new avenues of business
- Increase capital expenditure to enhance the business
- Making acquisitions
- Paying off debt
- Organic growth
What is the process behind an IPO?
An IPO for any company is a big step. This is possibly one of the biggest steps in the evolution of any company as it allows the company to expand greatly but also increases the risks, as it is now publicly traded. There are a few steps a company needs to take to have an IPO, these steps have been mentioned below:
Step 1: Selecting an Investment Bank
When a company decides to have an IPO one of the first things it should do is employ an investment bank to underwrite its offering. The investment bank also provides the issuer with valuable advice on the IPO. Due to how involved this bank is going to be in this crucial step there are a few criteria to consider while selecting a bank:
- The reputation of the bank
- The expertise of the bank
- The research methodology
- Channels of distribution of issued securities
Step 2: Underwriting Methods
An underwriter acts as an intermediary between the issuer of securities and the investing public. Underwriting is done to promote the IPO and make sure the company is able to sell its first batch of shares. There are three underwriting arrangements available.
- Firm Commitment: Under this type of an arrangement the underwriting firm buys a large portion of the IPO and resells it to the public. This is the most common type of underwriting as it guarantees the issuer a certain sum will be raised through the IPO.
- Syndicate: For risky IPOs, a single investment bank will form alliances with other banks to distribute the risk. This will distribute the IPO among a few banks so that if it is an unsuccessful IPO, the loss is spread among a few banks and not concentrated.
- Best Efforts Agreement: Under this agreement, the underwriter does not give any guarantees to the issuer. The underwriter will assure the issuer they will put in their best efforts to make the IPO a success.
Step 3: Engagement Letter
The engagement letter is between the issuer and the underwriter. This letter states the rules of engagement during an IPO between the issuer and the underwriter. There are two main clauses included in this letter.
- Reimbursement clause: This clause mandates that the issuing company covers all the out-of-the-pocket expenses of the underwriter for the IPO. This is applicable even if the IPO is withdrawn.
- Gross Spread: The Gross Spread is arrived at by subtracting the underwriting price from the price at which the shares are sold by the underwriter.
Step 4: Letter of Intent
The letter of intent is created by the issuing company and typically contains:
- The nature of underwriting
- An agreement by the issuing company to fully co-operate with the underwriter
- An agreement providing the underwriter a 15% overallotment option.
Step 5: Underwriting Agreement
The letter of intent is applicable until the pricing of shares takes place. Thereafter, the Underwriting Agreement takes over.