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What Is An IPO?

After all the excitement of last week, IPOs are the hot topic of the moment. But what exactly is an IPO, and how should we behave as investors when a new company hits the market?

Last week we were treated to one of the biggest spectacles the tech world has seen in a long time – Snap Inc finally went public.

After months of speculation, and more than its fair share of hype, the parent company of the infamous Snapchat app was finally floated on the New York Stock Exchange. Shares were valued at $17 the evening before, but they started selling two hours after the market opened last Thursday for about $24 a share. This valued the company at $33 billion and made an instant billionaire out of its 26-year-old founder, Evan Spiegel.

We’re not jealous at all.

But amidst all the excitement, some people were left with questions about the nature of IPOs. Sure, we all know that they have something to do with a company going public on a stock exchange. But what exactly does the process of an IPO involve? Why do some companies even file for an IPO in the first place? And what should we do as investors when a hot new company hits the market?

What is an IPO?

IPO stands for Initial Public Offering, and as you might have guessed, it is the process through which companies must go in order to sell shares in their business on the public market.

All companies typically start out as a private entity, which means that an individual or collection of individuals are the only stakeholders involved. Companies like Levi’s or Deloitte are good examples of businesses that have remained private and are run by partners or boards, with little to no public investment.

However, as some private companies get bigger, they might wish to go public for a host of reasons that we’ll explain in a minute.

In order to go public, they must go through the process of an IPO however, of which there are three main stages:

 

 

1. Underwriters

The first stage of an IPO involves the company hiring an investment bank like Goldman Sachs or JPMorgan Chase.

These banks, also known as underwriters, act as a kind of middle-man for the company as they work out the specifics of their public offering. These details will include what percentage of the company will be offered to the public, how much the business is aiming to raise from going public, and how many shares they plan to offer.

Underwriters are sometimes seen as a formality that companies wishing to go public must go through just for the sake of it. However, one important function underwriters perform is that they agree to buy a portion of shares set to be made public themselves. This guarantees that the company will make a minimum amount of cash from the flotation, while the underwriters can make money by selling off the stock once the IPO is complete.

2. SEC Filings

Once the details of the planned IPO have been sketched out, the company then prepares all the necessary documents that they need to submit to the SEC (Security and Exchange Commission) for approval.

These documents will include the specific details of the offering (how much is being sold, the proposed share price, etc), past financial statements, information about the management of the company, and a host of other background checks that will help ensure the company is doing everything by the books so far.

Once the SEC approves these filings, an effective date for floatation – or the shares becoming available to the public on the market – can be set.

It’s important to note that once a firm goes public, it falls under the remit of the SEC. This means that all the practices within the company will be regularly scrutinized by the organization in order to protect the interests of public shareholders.

3. Road-Show

Between the approval of documents and the date they finally go public, it’s in the interest of both the company and the underwriter to drum up as much publicity as possible. By getting the media talking about the impending IPO, investors will become aware of the company and its outlook which usually drives the potential share price up.

To do this, a prospectus is produced for the company and they embark on what is known as a ‘road show’. As you can probably guess, this is just a way to get people talking about the company.

The recent floatation of Snap Inc is a good lesson in the power of promotion. News channels obsessed over every inch of ‘the hottest tech IPO since Facebook’ for months, which made the market as a whole sit up and take notice when the IPO did roll around.

The final share price before the IPO is determined by measuring the company’s actual prospects against the sentiment of the market in general. This price can be set as late as the evening before the IPO. However, this is rarely the actual price that shares are first sold to the general public at.

Instead, significant portions of shares are first offered to large institutional firms behind the scenes. These are the guys’ underwriters want to target because of their massive buying power. These firms will buy multi-million dollar stakes in the company at the established opening prices, and then try to gauge the market’s attitude toward the company.

What they are trying to do is establish exactly how much investors are willing to pay for part of this company. Sometimes, it will be a lot more than the opening share price, sometimes it will be a lot less. It all depends on the sentiment of the market and the belief in the stock. This is precisely the reason why Snap Inc really IPO’d for $24 and not $17 as first priced.

 

 

Why do companies file for IPO?

There are many nuanced reasons why different companies file to go public, but in the end, it can all be boiled down to one very obvious reason – money!

There are a few different ways in which this money can be used however.

One of the main reasons a company will float is to repay their early investors. When a business is in its infancy, it needs regular injections of cash from private investors and venture capitalists, who quite often pump millions of dollars in for the first few years. A company going public is a way for these early investors to profit heavily from those early investments.

On the other hand, some people think that companies only IPO when they have reached the peak of their growth. It might be a slightly cynical attitude to take, but it’s a widely held belief that a company will never look as good as it does in its IPO prospectus. In this way, some business analysts think that floatation might actually signal a slowdown in growth and that the company hopes to boost its future with a cash injection from selling shares.

There are plenty of other reasons for IPOing though. A company might want to raise cash in order to increase the liquidity of the company’s books. Maybe they want to raise money so they don’t have to ask a bank for it. In fact, if a public company does need to borrow from a lender in the future, they’ll tend to get better rates on the debt they incur if they are publicly traded because their financial actions are safeguarded by scrutiny from the SEC.

Having publicly-issued stock can also be useful for a company in terms of future business transactions. Employees can receive company stock as a bonus, CEOs and other members of the board can buy-back stock as a sign of confidence in the company, or stock can be issued in lieu of cash as part of future merger and acquisition plans.

So what do I do?

So now that we know what an IPO is and why some companies go public, how should we behave as long-term investors?

Let’s look at Snap Inc again. Prior to the recent IPO, and thanks to the power of their ‘road show’, we received plenty of inquiries from users asking if we would be featuring the company in our app.

We haven’t added the company to our showroom yet, but we have been keeping a close eye on it and will continue to do so. Although they created and successfully marketed a hugely influential mobile app, the simple fact remains the Snap Inc is currently unprofitable and doesn’t look likely to turn a profit anytime soon. They might be bringing in impressive revenue figures, but they are also spending vast amounts of money in order to bring in that cash.

Indeed, after the initial hype around Snap Inc’s floatation last week, market sentiment has changed over the past few days and the share price has fallen significantly.

That’s not to say that we will never feature the company. But in the first few days of any company going public, the share price will be extremely volatile as traders hop on and off the bandwagon.

This goes for any company though. When a company files for IPO, it’s important to practice patience and only invest once you understand their long-term prospects and true value. Don’t worry about getting in from the very start – great companies will continue to grow long into the future.

The most important thing is to make sure that it’s actually a great company to begin with.

 

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