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What are IPO's (Initial Public Offerings)? Here's the full breakdown

At a glance:

  • The first steps to issuing securities to the public

  • IPOs: The basics of underwriting

  • IPOs: Types of underwriting arrangements

  • What you learn from an IPO prospectus

  • Types of IPO advertising

  • Hot issues, free-riding and withholding, and 'when, as, and if-issued' stocks

  • Summary of Initial Public Offerings

The first time a corporation offers its stock for sale to the public is called an initial public offering (IPO). Many companies are privately held, and their stocks are not for sale to the public. But when a company wants to expand, it often finds it advantageous to offer its stock to the public on the primary market. This way it can raise new capital or fund its future growth and operations.

Most times, investors buy or sell stock on the secondary market, either over-the-counter or on an exchange. When a new company offers its stock for the first time, savvy investors may be quick to get in on the IPO because of its short-term growth potential on the secondary market.

But you really have to know what you are doing, and you have to know enough about the IPO to avoid making a disastrous decision.

The first steps to issuing securities to the public

Corporations sell stock to the public as one way to raise capital. Before it can issue new stock, a corporation must first file registration statements with the Securities and Exchange Commission (SEC). A twenty-day wait is required before it can sell the stocks.

The red herring

The issuing company may make its registration statement public with a preliminary prospectus called a red herring.

The red herring summarizes the registration statement. Basic information about the new offering is also provided. This includes how many shares are being offered and which brokerage companies will help distribute the stock to the public.

The final prospectus

At the time of issue, a final prospectus is presented. It includes the price of the stock (its offering price).

IPOs: The basics of underwriting

A corporation going public hires an investment banker to help it sell its stock. This process is called underwriting. The investment banker functions as an intermediary between the issuing corporation and the public. In most cases, the underwriter (investment banker) purchases the stocks from the company for resale to the public.

The role of the syndicate

To reduce its own risk, the investment banker may form an underwriting syndicate of other investment bankers to co-purchase the shares. The underwriting syndicate forms a selling group to sell specified allotments of the issue.

The investment banker (underwriting syndicate) then marks up the price of the offering. This markup represents the fee for the syndicate's service. The difference between the price the underwriter pays and the price the public pays is called the underwriting spread.

Some legal issues

The syndicate manager may bid on the stock in the offering to "stabilize" the price. This bid must be less than or equal to the offering price. By law, the prospectus must make this attempt to stabilize the stock price known to the public.

The Securities and Exchange Commission also requires the underwriter to investigate the issuing company—particularly any audits, how it uses proceeds, its financial statements, and the management team. This process is called due diligence.

IPOs: Types of underwriting arrangements

Before shares of stock may be purchased by investors, they are first purchased and sold by an investment bank known as an underwriter. The underwriter acts as an intermediary between the issuing company and the public. A stock issue can be underwritten through several methods.

The agent

The underwriter can act as an agent, in which it tries to sell as much of the issue as it can at market prices. This is called a best efforts arrangement.

All-or-none arrangements

The issuing company can also agree to issue new stock on the condition that all of it be sold; if it isn't, then it will withdraw the issue. This is an all-or-none arrangement.

Negotiated underwriting

A negotiated underwriting is one in which the issuer and the corporation negotiate the terms of the issue, the price, the size, and other details.

Competitive bids

The issue may be subject to competitive bids from investment bankers. The top bidder underwrites the issue and resells it to the public.

Pre-emptive rights

When a public company issues more of its stock, it must first offer that stock to existing shareholders; that is their pre-emptive right. A standby is the public sale of whatever stock the existing shareholders haven't bought.

Firm commitments

A firm commitment arrangement is one in which an investment banker buys all of the stock from the corporation and then resells it to the public at a higher price.

Private placements

A private placement is an offering in which the company sells to private investors and not to the public. Private placements do not have registration fees.

When you are buying stock in an initial public offering, or IPO, it is important to understand the underwriting arrangement, because it can impact the performance of the new stock on the secondary market. The size and prestige of the underwriters can also be a clue to the strength of the offering. You can read about the stock's underwriters in the prospectus.

What you learn from an IPO prospectus

Prospectuses are legal documents that explain the financial facts important to an offering.

They must precede or accompany the sale of a primary offering. The law requires companies selling primary offerings to send prospectuses out to anyone who wants to buy a primary offering. Prospectuses may also be used to solicit orders. Customers should read a prospectus carefully before purchasing any primary offering.

What you'll find in a prospectus

Prospectuses include but are not limited to the following:

  • Offering price

  • Legal opinions about the issue

  • Underwriting method

  • The history of the company

  • Other costs related to investing in the stock

  • The management team

  • The handling of proceeds

Some rules to follow

The prospectus must be provided to customers before they complete any transactions. It must also include the Securities and Exchange Commission's disclaimers that it does not approve or disapprove of the stock being offered, and that it does not judge the prospectus' statements for accuracy.

Types of IPO advertising

A new issue of stocks is allowed to be advertised before it is actually sold, although it may not be sold during the actual registration period.

What registered representatives may and may not do

Registered representatives are allowed to accept oral solicitations from clients. They are not allowed to sell any shares of the new stock. Neither are they allowed to affirm any offers of sale.

Registered representatives may send red herrings, or preliminary prospectuses, to clients. Red herrings note vital information about the stock and its issuer. Information includes such important financial data as the offering timetable and why the stock is being sold. Red herrings are issued only for information purposes.

Tombstone advertisements

Tombstone advertisements are ads that announce the new stock. Their sole purpose is to function as communication. They are not prospectuses. They are called tombstones because they provide prospective buyers with the "bare bones" information: the name of the stock, the issuer, and how to obtain a red herring.

Hot issues, free-riding and withholding, and 'When, as, and if-issued' stocks

Three aspects of initial public offerings deserve special attention: hot issues, free-riding and withholding, and the so-called "when, as, and if-issued" stocks.

Hot issues, and free-riding and withholding

A hot issue is a security sold by broker-dealers on the secondary market just after it is first issued. If a broker-dealer buys a hot issue and withholds it from sale to get a higher price later, the broker-dealer is engaging in an illegal practice called "free-riding and withholding."

This is illegal because it robs the public of its chance to buy the stock at a fair price. The prohibition extends to financial dependents and immediate family members of broker-dealers.

New stock may not be sold until after the registration period has expired.

‘When, as, and if-issued’ stock

If the stock has not been issued by that time, it may be sold conditionally as a "when, as, and if-issued" stock. Should it fail to be issued, all buys, sells, earnings, and losses will be canceled.

Summary of Initial Public Offerings

The initial public offering (IPO) has received much acclaim in recent years due to news stories about small, unseasoned companies going "public" and their shareholders being skyrocketed into instant wealth. Surely, these stories are the exception rather than the rule.

All public companies at some point have an initial public offering. By doing your homework, you should be armed with information about an IPO so you are able to judge whether investing in it fits your investment objectives and risk tolerance.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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