New Issues and IPOs
What Is an IPO?
An IPO (initial public offering) is an offering of stock in a formerly privately-owned company to the general public. In recent years we have all become accustomed to the phenomenon of the IPO. We have seen spectacular launches, particularly of technology companies, where the founding owners become - literally overnight - millionaires.
How does it work?
When a company wishes to go public, it commissions an underwriter to help. The underwriter, usually an investment bank, will agree to buy a minimum number of shares from the issuer - effectively insuring the flotation. The underwriter will then sell on the company's shares to other buyers, usually their clients or perhaps the underwriter's broking operation.
While the underwriter makes large fees for its service, it risks getting stuck with shares worth less than the price it struck with the issuer if there is insufficient demand for the stock.
At the next stage the company and the underwriter set the flotation date and issue a preliminary prospectus. This document gives detailed information about the business so investors can make an informed judgment about the company's prospects.
The preliminary prospectus also gives an indicative offer range (price) for the stock. This price, however, is subject to change right up to the issue and will usually be affected by perceived demand for the stock in the market and by general market conditions.
Can I get in on an IPO?
Demand for IPO stock can be tremendous and offerings are frequently oversubscribed. The result is that the stock price appreciates greatly on the day of flotation.
For the ordinary investor it is not easy to get in on an IPO. The reality is that the underwriter or broker usually reserves IPO stock for its most favoured clients; often these are large institutional investors or high net worth private clients.
The first chance a private investor may get to buy the stock is often on the open market, where ultimately it may trade far higher than the issue price.
Unless you have a very close relationship with your broker, you are unlikely to get in on an IPO at the issue price. In that case, you might be tempted to buy on the open market following flotation. But beware that initial investors will usually try to take a profit soon after the flotation and this can depress the share price dramatically.
The best chance the private investor has of buying stock at the issue price is with government offers of formerly state-owned industries. Often the government will reserve a substantial proportion of the available stock for small investors.
Regardless of how heavy demand is and how high the stock price climbs, the company only gets the issue price minus the costs of flotation. The difference between the market capitalisation post-flotation and the nominal value of the shares issued represents the gain made by the IPO investors.
Often companies release a relatively low proportion of capital to the public at the time of the IPO so there may be only, say, 20% free capital or Free float. This is often insufficient to meet demand and can drive up the stock price and market capitalization significantly.
Watch out for those companies that have a large market capitalisation post-flotation but have an excessive "burn" rate on relatively low levels of cash raised at the time of the flotation.
This leads to an increased risk of failure if the cash runs out and investors no longer have the appetite for the stock in question should it need to go to the market again.