What is IPO: Purpose, Types, Eligibility & Process

You may have heard of an IPO and wondered what this thing is. An Initial Public Offering (IPO) is a vital moment for any company making its leap from a private entity to a publicly traded one. Allow me to walk you through the ins and outs of an ideal IPO process with examples from different countries. 

What is an IPO?

An Initial Public Offering (IPO) is the process by which a private company offers its shares to the public for the first time, transforming into a publicly traded company. Through an IPO, a company sells part of its ownership to raise capital from a pool of investors. This event is a significant milestone, signaling the company's growth and allowing it to access public capital markets for further expansion.

Purpose of an IPO

The primary purpose of an IPO is to raise funds to support the company's growth objectives, such as developing new products, expanding operations, or paying off debt. Additionally, it provides early investors and company founders the opportunity to monetize their investments. Once a company goes public, it can also gain increased visibility and credibility.

Process of Going Public
The IPO process involves the following steps:

1. Preparation: The company must ensure its financials are in order by working with an investment bank to determine the valuation and structure of the offering.
2. Filing with Regulatory Authorities: In the U.S., this involves submitting a registration statement, such as an S-1, to the Securities and Exchange Commission (SEC).
3. Roadshow/Media/Ad campaigns: The company and its underwriters promote the offering to potential institutional investors through a series of presentations.
4. Pricing: Based on investor demand during the roadshow, the final price per share is determined.
5. Public Trading Begins: Once the IPO is launched, the company's shares start trading on a stock exchange, such as the NYSE or NSE.

Types of IPOs

1. Fixed Price Offering

In a fixed price offering, the company sets a specific price at which its shares will be offered to the public. This price is determined based on the company’s valuation and market conditions. Investors are informed of the price before the IPO, allowing them to decide whether or not to subscribe to the shares.

Example: A company decides to issue 1 million shares at a fixed price of $20 per share. Investors know upfront that they will pay $20 per share if they choose to invest.

2. Book Building Offering

In a book-building offering, the final share price is not fixed beforehand. Instead, the company provides a price range, and investors place bids within that range. The company then determines the final price based on investor demand and the bids received.

Example: A company sets a price range of $18 to $22 per share. Investors bid on how many shares they want to buy and at what price within that range. If demand is high, the final price might be set at the upper end of the range.

3. Direct Listing

Unlike traditional IPOs, a direct listing does not involve issuing new shares or raising new capital. Instead, existing shareholders (such as employees and early investors) sell their shares directly to the public. This method is often used by companies that don’t need to raise additional funds but want to provide liquidity to existing shareholders.

Example: Spotify used a direct listing to go public, allowing its shares to be traded on the New York Stock Exchange without raising additional capital.

4. Dutch Auction

In a Dutch auction, potential investors submit bids indicating how many shares they want to buy and at what price. The company then sets the price at which the total offering can be sold based on the highest bids. All investors pay the same price, which is the lowest price at which the company can sell all its shares.

Example: Google used a Dutch auction for its IPO in 2004, allowing a more comprehensive range of investors to participate by determining the price based on demand.

The IPO Process

For this part, allow me to base the process of launching an IPO on UK regulations, which involves several players and steps (in brackets are the US equals):

1. Preparation (Company Preparation)

1.1. Assessing IPO Readiness

The company must conduct an internal review to assess its readiness for an IPO. This includes evaluating financial health, corporate governance, and operational maturity. The company’s management must also be prepared to meet the demands of public ownership, including increased transparency and regulatory scrutiny.

The company also hires financial and legal advisors, such as investment banks, accountants, and law firms, to guide them through the IPO process. These advisors help in preparing the company for listing and walking the regulatory setting.

1.2. Choosing the Right Market

In the UK, companies can choose to list on the London Stock Exchange (LSE) or AIM (Alternative Investment Market). The LSE is the primary market for larger, established companies, while AIM caters to smaller, growing companies. The choice of market depends on the company’s size, growth stage, and capital needs.

1.3. Structuring the IPO

The company, in consultation with its advisors, decides on the structure of the IPO by determining the number of shares to be issued, the pricing mechanism (fixed price or book-building), and whether existing shareholders will sell their shares in the offering.

The critical step in the IPO process is determining the company’s valuation, which influences the share price. A contracted investment bank conducts a valuation analysis, considering factors such as the company’s financial performance, market conditions, and industry trends.

2. Regulatory Compliance Documentation (Regulatory Filings)

2.1. Prospectus Preparation

Drafting the Prospectus: The prospectus is a comprehensive document that provides potential investors with detailed information about the company, its business model, financial performance, risk factors, and the terms of the offering. It must comply with the UK Listing Authority’s (UKLA) rules and regulations.

Once the prospectus is drafted, it must be submitted to the UKLA for approval. The UKLA reviews the document to ensure it meets all regulatory requirements. The approval process can take several weeks, during which the company may need to make revisions.

2.2. Legal and Financial Due Diligence

Legal and financial due diligence is conducted to verify the information presented in the prospectus. This involves a thorough review of the company’s financial statements, legal contracts, intellectual property, and other critical aspects. The due diligence process helps identify any potential risks that could affect the IPO.

2.3. Corporate Governance Compliance

The company must ensure that its board of directors meets the corporate governance standards required for a public company. This includes having independent directors and establishing audit, remuneration, and nomination committees.

The company must comply with the ongoing regulatory requirements for listed companies, including disclosure obligations, financial reporting, and shareholder rights.

3. Marketing and Investor Relations (Roadshows)

3.1. Pre-IPO Marketing

Before the IPO, the company and its advisors engage in pre-IPO marketing activities, also known as "roadshows." During these roadshows, the company’s management team meets with institutional investors, analysts, and potential buyers to present the investment case and generate interest in the offering.

The roadshow helps in price discovery, where the company gauges investor interest and determines the final offering price. If the IPO is structured as a book-building offering, the price is set based on bids received from institutional investors.

3.2. Investor Education

A solid public relations strategy is essential for building investor confidence and educating the market about the company’s prospects. This includes media appearances, press releases, and investor presentations.

4. Launching the IPO

4.1. Setting the Offer Price (Pricing)

After completing the roadshow and gathering investor feedback, the company, in consultation with its advisors, sets the final offer price for the shares. This price is announced publicly just before the shares start trading.

The company allocates shares to investors, prioritizing institutional investors who have shown strong interest during the book-building process.

4.2. Listing on the Exchange (Allocation and Listing)

The company applies for admission to trading on the selected exchange (LSE or AIM). Upon approval, the company’s shares are officially listed, and trading begins. The first day of trading is a significant milestone, with the company’s stock price closely watched by investors and market analysts.

4.3. Post-IPO Compliance Reporting

After the IPO, the company must comply with ongoing reporting and disclosure requirements, including quarterly and annual financial reports, prominent event disclosures, and maintaining good corporate governance practices.

The company must maintain transparent communication with its shareholders, including holding annual general meetings (AGMs) and providing regular updates on business performance and strategy.

Eligibility for Participating in an IPO

Eligibility to participate in an IPO can vary depending on the country, the regulatory framework, and the rules set by the company offering the IPO. Here are the general criteria:

1. Investor Eligibility

In most cases, retail investors can participate in an IPO through their brokerage accounts. They may need to meet specific criteria, such as having a minimum account balance or demonstrating sufficient investment experience.

Large financial institutions, such as mutual funds, pension funds, and hedge funds, are often given priority access to IPO shares. These investors typically have the resources and expertise to buy large quantities of shares.

Some IPOs have a reserved portion for high-net-worth individuals(HNIs) with substantial financial assets. These investors often receive favorable treatment in the allocation process.

2. Account Requirements

To participate in an IPO, you must have a brokerage account with a financial institution that has access to the IPO market. Not all brokers offer IPO shares to their clients, so it's important to check with your broker in advance.

In some countries, such as India, a demat (dematerialized) account is required to hold and trade securities electronically. This account is necessary for participating in an IPO.

Know Your Customer (KYC) compliance is mandatory for participating in an IPO. This involves verifying your identity and address through your passport, identity card, or driver's license.

3. Financial Requirements

Some IPOs have a minimum investment requirement, meaning you must purchase a certain number of shares or invest a minimum amount to participate.

In a book-building IPO, you will be required to submit a bid application indicating the price you're willing to pay for the shares and the quantity you want to purchase. The final allocation depends on the demand and the final IPO price.

4. Lock-In Period

Company insiders, i.e., founders, executives, and employees, may be subject to a lock-in period, during which they cannot sell their shares. This period is usually 6 months to a year, depending on the regulatory requirements.

Retail investors do not have a lock-in period, so they can sell their shares as soon as the stock starts trading on the exchange. However, you should be aware of potential price volatility immediately after the IPO.

5. Regulatory Compliance

Each country has its own regulations governing IPO participation. For example, in the United States, the Securities and Exchange Commission (SEC) regulates the IPO process, while in India, it's governed by the Securities and Exchange Board of India (SEBI). Investors must adhere to set regulations when participating in any IPO.

An IPO is not just a financial event; it's a strategic move that opens doors to new opportunities. By going public, companies gain access to a vast pool of capital, enhance their market visibility, and offer early investors a chance to realize their gains.