Oh hi, this is an Editor’s Note: While Bumped doesn’t participate in IPOs, we still think the process of how they happen is worth talking about. So here we are, talking about it.
An Initial Public Offering (aka IPO) is when a company begins selling shares of its stock to the general public for the very first time.
Before an IPO, the only shareholders are usually people like the founders, family and friends, early employees, and professional investors. Afterwards, shares can be bought and sold on public stock exchanges (hence the phrase “going public.”)
Why go public?
The most common reason for going public is to raise capital.
While private companies can raise money by finding more private investors or taking out loans, IPOs typically result in larger amounts of capital for the company. IPOs don’t necessarily indicate that a company has figured out how to be profitable—Salesforce, Tesla, Amazon, and Twitter, for example, all IPO’d before profitability.
Instead, it can mean that they’re hoping to raise large amounts of capital, which they’ll use to attempt to grow their business.
Why stay private?
For one thing, public companies in the U.S.
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are required to publicly disclose all relevant financial accounting information to the Security Exchange Commission (SEC) every quarter. Privately held companies don’t have to do that.
Instead, they can keep much of their financial info, well, private.
Stock exchanges may also have their own rules and requirements that public companies must follow in order to have their shares listed.
Staying private can also give companies more freedom to adapt strategy.
In the case of SpaceX, being private allows Elon Musk the flexibility to make long-term strategy decisions that shareholders in a publicly traded company might push back against—as they may be more focused on current earnings.
How do IPOs work?
When a company decides they want to go public, the road to get there can be lengthy. While not all paths to public look exactly the same, the usual route is something like this:
- The company hires an investment bank to be the “underwriter” (aka the go-between for the company and the public) to market and sell the initial shares.
As you can imagine, a single investment bank might not want to shoulder all of the potential financial risk of an IPO, so they often team up with other investment banks to form what’s called a “syndicate” (a group of investment banks involved in an underwriting).
In an Agreement Among Underwriters (AAU), the syndicate decides which underwriter is in charge of what, how many shares each will be allotted and responsible for selling, who the lead underwriter is, and what each underwriter might be compensated.
Once the syndicate is in agreement, the lead underwriter and company put together an Underwriting Agreement which includes stuff like:
- The desired public offering price or range.
- How much the underwriters will make from selling the shares (this is often called an “underwriting spread” and it’s the difference between how much the underwriter will pay for the shares and what they plan to sell them for).
- Once agreements are agreed upon, the lead investment bank puts together a registration statement to be filed with the SEC.
This statement contains info about the offering as well as company data—including a description of the company’s properties and business, a description of the shares to be sold, info about the management of the company, and financial statements certified by independent accountants—as well as the proposed ticker symbol that the company will trade under once it’s been listed on a stock exchange.
Included in the statement is a “red herring document” (also called a preliminary prospectus, the name comes from the red warning on the front cover noting it’s not a final document).
The red herring document includes all of the info a potential shareholder might need to make a solid investment decision, save for the offering price—which hasn’t been decided yet.
- After the registration is filed with the SEC, there’s a required “cooling-off period.” During this time, the SEC takes a minimum of 20 days to make sure that everything that’s supposed to be in the statement is indeed in the statement.
Fun fact: the SEC never “approves” a registration, nor do they make a call on whether the statement is accurate or if it’s a good investment.
They just make sure the required information is there.
Meanwhile, the lead underwriter and the company go on a “road show,” where they share the red herring document and potential price range to gauge interest in the offering.
While selling the shares during the cooling-off period is not allowed, the SEC does allow some advertising, so long as any ads include only general info about the offering.
Often, it’s presented in what’s called a “tombstone ad”—an ad in a newspaper or magazine that contains a black border kind of resembling a tombstone.
Tombstone ads simply tell the public about the future offering and will typically include info like the potential price range of the shares, how many will be included in the IPO, who the underwriters are, a brief description of the company selling the shares, and the expected ticker symbol and exchange where the shares will be listed.
- If the SEC finds no material omissions or issues with the registration, it becomes "effective" after the cooling-off period.
Initial Public Offering (IPO) Process
(If they do find an issue, the company has to then file an amendment, which tacks on another 20 days for review.)
After the registration becomes effective, the company is technically allowed to start selling shares to the public—but first they need set the price.
The price often depends on how well the road show went. If it went well and interest is high, then it’ll typically be at the higher end of the price range.
But if interest was low, they’ll set a lower price.
- As soon as the price is determined, it’s inserted into the red herring document to create a final prospectus—which is filed with the SEC and serves as the disclosure document for customers who participate in the IPO.
- The IPO happens! After that, the company is officially publicly traded and its stock can be bought and sold in the market.
While the path to being publicly traded can vary—Spotify, for instance, skipped the underwriting step and did a direct listing themselves—IPOs are more common.
So the next time you hear about a company having one, you’ll know what it means.