What is IPO (Initial Public Offering)?
It’s a rare business which doesn’t feel the need for an input of cash at some point in its life cycle. When the profits obtained through organic growth aren’t sufficient to meet the costs of innovation or other expensive undertakings, several options are available. The company directors might choose to take out a bank loan, launch a pitch for crowdfunding, or even decide to issue bonds. However, some companies generate capital through an Initial Public Offering (IPO) of shares.
An Initial Public Offering is the means by which a private enterprise ‘goes public’, thereby becoming a publicly listed company (i.e. one whose shares are freely traded on the stock market). In conducting an IPO, the company in question is effectively approaching the market to raise fresh capital. As mentioned above, this injection of capital may be required for any number of reasons, but a common use for funds raised through an IPO is to realise expansion plans.
How is an IPO Conducted?
The IPO process is closely regulated and complex, so—unless they’re raising money through crowdfunding--a company will never offer shares directly to the public. Instead, they’ll hire a syndicate of investment banks to underwrite the deal. For a fee, the bank leading the syndicate conducts an in-depth analysis to ascertain how much money is to be raised and how many shares will be issued, and then assigns a unit price to these shares. The exact nature of every IPO agreement is different. However, one common example is where the banks in the syndicate each undertake to buy a pre-agreed portion of the share issue (in a process known as the primary market), which they will then sell on to the general public (in the secondary market).
Pros and Cons of Making an IPO
IPOs are a mixed blessing for companies: becoming publicly listed comes with a heavy roll-call of regulatory obligations, plus duties towards shareholders. There’s also an up-front financial cost in the shape of fees payable to legal advisors, analysts and underwriters. But the most obvious advantage of making an IPO is the ability to raise a large sum of capital from investors without the requirement to pay a fixed return.
Should You Buy an IPO?
Because an IPO represents a rare opportunity for the small investor, it’s usually an opportunity heralded by a huge amount of media hype. This, together with the understandable enthusiasm to buy into a company whose activities are inspiring, can generate something of a feeding frenzy on the first day of trading. Although IPOs can be profitable, academics and commentators have observed that it makes financial sense to hold back for a few months, when the share price often drops considerably.
Although making an Initial Public Offering requires much careful planning and some expense, it’s an excellent way for a profitable business to raise the funds to expand. However, it’s important for the small investor to be aware that the pricing of IPOs depends on multiple factors, and is therefore an inexact science. And while it’s true that you have only one chance to buy a piece of an IPO, the Initial Public Offering probably won’t represent your one and only chance to invest in the company.