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Traders' views - Stock trading

What is an IPO? A beginner's guide to flotations

By , 12 Oct 2012

IPO (Initial public offering) or flotation is how companies make their shares available for trading on the stock market – and raise some money in the process. 

This can involve the almighty public launches such as the case of Facebook’s Mark Zuckerberg recently or the brains behind Google a few years back. Or it can involve small fundraisings of just £1m as you might see on London Stock Market’s growth arm, AIM.

Effectively the procedure makes shares in a formerly privately-owned company available to the general public, and it can also be known as ‘going public’ or ‘taking a company public’.

How does the IPO process work?

When a private company decides it is going to public, it employs for a hefty fee one or more underwriters, typically investment banks, to help by agreeing to buy a minimum number of shares from the issuer – effectively insuring (underwriting) the flotation.

The main underwriter in a syndicate of investment banks, also known as a ‘lead runner’ or ‘bookrunner’, will then sell on the company's shares to other buyers, usually their clients or perhaps the underwriter's broking operation. Unless the IPO is particularly huge or complex, one company will takes the responsibility of running the books, otherwise multiple firms or ‘joint book runners’ can manage a new issuance.

Then the company and the underwriter set a tentative date for the flotation date and issue a prospectus or offer document. In the US, the preliminary prospectus issued during the ‘initial quiet period’ when shares cannot be sold but indications of interest gained, is known as a red herring prospectus due to its red text. This text gives reams and reams of detailed information about the business and possible risks, director biographies, associated company, plans and strategies, incentive schemes, so investors can make an informed judgment about the company's prospects.

How the price is set – pricing an IPO

The prospectus also gives an indicative price or offer range for the stock, which can be subject to change right up to the issue. Facebook’s price climbed up and up and up in the weeks and months leading up to it’s IPO – and is a magnified indication how the offer price can be affected by perceived demand for the stock in the market and by general market conditions.

There are two primary ways in which the price of an IPO can be determined. Either the company, with the help of its lead managers, fixes a price (fixed price method) or the price can be determined through analysis of confidential investor demand data, compiled by the bookrunner. That process is known as book building.

For example, on a massive IPO the company – the issuer – might for example have UBS as the lead underwriter with four additional joint bookrunners (Morgan Stanley, Banco Santander, Goldman Sachs and Credit Suisse, say) in order to try to improve the offer price.

These bookrunners will then work to find syndicates and other underwriters who will place the shares with investors. The next step is to take the offer on road shows and work towards finalising discussions about the best offering price and the timetable for the flotation.

There is always a risk that the required funding will not be raised, as happened many times even to large organisations like Formula One last year in its repeated attempts to float.

Why will companies be floating?

Most IPO are from fast-growing business in need of expansion funds. Although other common reasons are to give the company the future possibility of using its shares as currency for expansion, to allow the founders or private investors can extract some cash from the business and allow a professional board of directors to take it to the next level, or to enable the company to increase its shareholder base.

If a company’s owners and main investors are selling out and not retaining much of a share, that should make investors immediately cautious about putting their money in its place. A ‘lock-in period’, which prohibits directors and other insiders on the IPO from selling any shares for a specified period, is a common practice to try and increase stability in the shares after flotation.

Sometimes less optimistic directors or others given equity as part of their involvement in the deal will take the first opportunity to take a profit and so when this period ends they will sell and the price will skip downwards. This can be a great buying opportunity for shrewd traders – or an indication that the company does not even have the confidence of its principal officers.

If it is the former, you need to assess the company’s trading performance, prospects and management in the same way as you would any other company, comparing it with others in similar industries and so on.

Warning: Remember, particularly if you are new to trading in the stock market and in forex, that the prices of shares and other investments can fall fast and you may not get back the money you originally invested. The material here is for general information only and is not intended to be relied upon for individual investment decisions. Take independent advice before making such decisions. Also, the BullBearings free stock exchange simulation portfolios are a good way to practice trading techniques.

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