Chinese e-commerce giant Alibaba recently made major headlines when it decided to go public. The company’s initial public offering (IPO) went on to become the largest in history. IPOs can be complicated business, and most companies carefully deliberate before putting effort into an IPO. Read on to learn what exactly an IPO is, why companies want to go public, and what different ways there are to go about it.

What is an IPO?

An initial public offering allows a private company to become a public company. Essentially an IPO is a stock market launch where the company’s stock can be bought by the general public. Private shares of a company are sold to big investors who then sell to the general public.

A private company may have only a few shareholders. Since it is private, it is not subject to the regulations of the Securities and Exchange Commission (SEC). A public company is publicly traded and thus is subject to SEC regulation. An IPO is traditionally issued to smaller, younger companies hoping to gain capital to expand their business.

Why do companies decide to have an IPO?

IPOs are a great way for companies to quickly raise large amounts of capital to gain liquidity. This money can then be used to improve the company by reinvesting in its infrastructure or expanding the business. The major benefit to companies is that in selling shares they are never forced to repay investors the money they gain. Watch a video on some of the benefits of an IPO below:

Monetize the Investment

Many early investors or founders of a new company may be interested in cashing out their initial investment. An IPO easily allows them to do just that. The IPO provides an easy exit for angel investors or venture capitalists since they can cash out their investment by selling their shares of the company to the general public.

Increased Exposure

Going public means a company gains prestige and a better public image. Being listed in major stock exchanges such as NASDAQ or NYSE makes the public think more highly of the company and helps to garner media attention.

Benefit of Stock

Being able to offer stock gives the company options and flexibility. Employee stock ownership plans can help recruit top talent to the company. Further, the increased scrutiny that comes from SEC filings means the company can get better rates when it issues debt. Issuing debt allows the company to create other financing opportunities in the future.

What are the disadvantages of an IPO?

The immense legal, accounting, and marketing costs associated with the IPO process can be difficult for a smaller company to afford. The required time, attention, and effort of senior management take a significant toll and can hamper the company’s operations. The issuing of stock can also mean a loss of control for management, since shareholders may be given some say in the future direction of the company.

The requirement to disclose certain information in SEC filings is also a drawback for many companies. A publicly-traded company must have a board of directors and must report its financial information every quarter. This information could prove valuable to the company’s competitors.

IPOs can be risky for investors. It is tough to predict what the stock will do at the beginning of trading since there is no track record of the company to analyze. Since most IPOs are issued by companies going through rapid growth, there is a great deal of uncertainty in predicting how well the company will be doing in the future. Caution should be used when deciding whether to invest. Most experts say that small investors should wait a month or more to buy shares of an IPO so the price of the stock has time to settle down.

How does the IPO process work?

Given the concerns of going public, companies think long and hard before making the decision. The process is lengthy and very costly.

1. Once a company decides to go public, it will typically seek the assistance of an investment banking firm, such as Goldman Sachs or Morgan Stanley. The investment banking firm acts as the underwriter. Banks submit bids to companies going public with statements of how much money the company would make and what share the bank would make. This competition can be fierce, especially if banks think there is a lot of money to be made on the deal.
2. When an investment bank is hired, the company and the bank discuss how much money they will raise from the IPO, the type of securities to be issued, the price, when to bring the IPO  to market, and other details of the underwriting agreement. It is the underwriters’ job to make a large purchase of the firm and then facilitate the orderly sale of this initial stock. Underwriters make money through the fees charged to the company and by the stock they sell. The underwriter takes the risk that it will be able to sell the stock it bought from the firm for more than it initially paid.
3. The bank then puts together a registration statement called an S-1 to be filed with the SEC. This statement offers information about the company such as its past financial statements and any past legal issues. The SEC will investigate to ensure the information it receives is correct and to make sure all information has been disclosed. During this time the company will pick which stock exchange it wants its shares listed on.
4. The company will typically go on some sort of “roadshow.” It may travel to meetings across the country or online as a way to drum up investor interest in the IPO. Through attracting large investors in the roadshow, the company can then sell its stock in large blocks to institutional investors.
5. As the date of the IPO nears, the company and underwriter will agree on a price. They try to find a price low enough to generate interest yet high enough to raise money for the company. A certain percentage of shares, typically around 20 percent, are agreed to be sold. Institutional investors are often offered the first shares.
6. The underwriters sell their shares of stock to a large number of investors on the public market. The banks make their profit on the difference in price between what they paid before the IPO and what the shares sell for when officially offered to the public. Very rarely will small investors get some kind of IPO allocation. Typically they have to wait until the stock is listed on the exchange in a secondary offering. In a secondary offering, investors may sell a large block of their initial sales directly to the public.

Watch a basic overview of the IPO process below.

What are some alternative IPO methods?

There are numerous different ways of making a public offering. While most involve the basic process described above, the different methods alter specific elements of the IPO.

Venture Capital-Backed IPO

A venture capital-backed IPO is one in which management sells its shares to a group of private investors in exchange for funding and advice. This allows venture capitalists to effectively exit after creating a financially-stable company.

Reverse-Leverage Buyout

With a reverse-leverage buyout, the money made from an IPO is used to pay off debt accumulated while the company was private. By privatizing a publicly-traded firm that is undervalued on the market, the owners are able to make money once the public becomes aware of the high intrinsic value of the firm.

Dutch Auction

The idea of a Dutch auction was explored in the Google IPO. In a Dutch auction, the company reveals the amount of shares to be sold and a potential price. Investors state the number of shares they want and what price they want to pay. A minimum clearing price is determined, then investors who bid at or above that price are awarded shares. If there are more bids than available shares, the company awards a percent of shares based on the percent that was bid for. Investment banks do not typically like this arrangement since it offers equal access to shares to groups other than the underwriter. Further, if there is not strong initial demand for the shares, the auction could mean the company will not raise a lot of money through the IPO.

What are some recent examples of IPOs?

Prior to 2009, the United States was the leading issuer of IPOs in terms of total value. China has since taken the lead and become the new major IPO market. The number of IPOs is usually indicative of the health of the stock market and the economy. Most major IPOs in recent years were for technology companies.

On September 19, Chinese e-commerce giant Alibaba made its IPO debut. Trading went off without a hitch as Alibaba’s became the largest IPO ever at a whopping $25 billion. The IPO price was set at $68 a share, but shares opened more than 35 percent above the initial set price.

Facebook’s IPO in May 2012 made only $16 billion. Many cite Facebook’s mistake to be dramatically raising the price of shares and size of the IPO just before the date of the IPO. This led to rough trading and to the stock falling 50 percent in the first four months of public trading.

The recent success of Alibaba as well as other strong IPOs are seen as signals of stock market strength. Do not expect the increase in IPOs to slow down anytime soon.

Resources

Primary

CNBC: Initial Public Offering: CNBC Explains

Additional

Business Insider: The NYSE Explains How IPOs Work

The Share Centre: IPOs Explained: 10 Things You Need to Know

Business Insider: This Handy Infographic Explains How an IPO Actually Works

Wealth Lift: Initial Public Offerings Explained

Investopedia: IPO Basics: What is an IPO?

Seeking Alpha: Facebook IPO and Types of IPOs and After-Market Support

Investopedia: 5 Things to Know About the Alibaba IPO

CNBC: Alibaba IPO Biggest Ever; Shares Decline

Reference for Business: Initial Public Offerings

Mergers & Inquisitions: The Initial Public Offering Process: Got Facebook Shares?

USA Today: Why Alibaba IPO Fared Much Better than Facebook’s IPO

Alexandra Stembaugh

Alexandra Stembaugh graduated from the University of Notre Dame studying Economics and English. She plans to go on to law school in the future. Her interests include economic policy, criminal justice, and political dramas. Contact Alexandra at staff@LawStreetMedia.com.

The post The Alibaba IPO: What Does Going Public Mean? appeared first on Law Street.