IPOs

Understanding IPOs

This investing acronym has made its way into mainstream lingo. We often hear about initial public offerings (IPOs) when a hot new company decides to offer investors a piece of the action by “going public” —often garnering lots of media attention and excitement. But what exactly are IPOs and how do they work?

Let’s take a closer look.

An IPO to remember

Social networking company Facebook held its IPO on Friday, May 18, 2012. The IPO captured the world’s attention. It was the biggest in technology and one of the biggest in internet history, with a peak market capitalization of more than $104 billion.

What is an IPO?

An IPO is a company’s first offering of stock to the public. Companies typically use IPOs to raise capital for future business expansion, to pay down debt or to finance other corporate activities. This process is often called "going public."

The issue of an IPO is typically carried out through a number of securities dealers, usually banks or other large financial institutions. Once you own one or more stocks in a company, you are a shareholder and have a right to future profits distributed by that company.

Why do companies go public?

When a company goes public it gains a “seat at the table” of the debt and equity markets. This means that it can raise funds through public stock and bond offerings. Access to funds is important because cash is often required for investment and business growth. Private companies can raise funds too, but may have fewer options available.

Being a public company has other benefits, too. For example, a liquid, publicly traded stock can be used for acquisitions and employee compensation. And sometimes going public generates excitement and interest in a company, boosting its profile.

The tradeoff to going public is the costs associated with issuing an IPO, including fees that must be paid to the investment bank and legal fees for structuring and marketing the IPO.

There are also ongoing costs. Public companies must meet various standards of transparency and reporting, and there is a fee to have a company listed on a stock exchange. In some cases, the burden of being public outweighs the benefits.

The IPO process

When company owners make the decision to take their company public, they first hire an investment bank to help structure the deal and lead the process. The investment bank will help the company determine the amount of money to raise, appropriate terms and timing.

The investment bank serves as an “underwriter” of the deal. These bankers ensure that the company issuing the IPO satisfies all regulatory requirements, such as filing with the appropriate bodies, depositing all fees and making all mandatory financial data available to the public. The lead underwriter will often partner with other underwriters to form what is called a syndicate, thus spreading the risk of the deal.

Once the company’s IPO registration statement is filed with regulators there is a requisite "cooling-off period," during which the regulators perform due diligence on the company and the underwriters coordinate a "road show." The road show is designed to drum up demand for the deal, primarily with institutional investors who are able to make large investments.

The success of the road show will ultimately dictate the price at which shares are offered on the effective date (the date when stock is offered to the public).

And finally, the stock is sold to investors and the proceeds, after fees, go to the company.

The lockup period

Company insiders often sign an agreement with the underwriters that limits their ability to sell their shares for a post-IPO "lockup period." The period can range from three to 24 months.

The benefits of IPOs for investors

It’s easy to get caught up in the excitement when a company first goes public. But how do you determine whether or not to jump in?

The benefit of participating in any new issue (IPO or otherwise) always depends on the quality of the company doing the issue, the market’s view of that company, and the stock price or yield offered.

IPOs can provide excellent opportunities for capital appreciation when momentum in the secondary market grows, but this is not guaranteed. In other words, do your homework!

Weighing the risks

In some cases, IPOs may carry more risk than other types of equity investments. There are a few factors that can contribute to this risk, including:

• There may be less public information available about the company, and share price history may be limited or non-existent;
• Some investors look to quickly flip their investment in an IPO. In some cases this can cause the share price to drop shortly after the stock goes public;
• Insiders may unload their shares and drive down the price after the lockup period expires;
• Excessive hype surrounding a new issue can drive the initial price higher; and
• A company may have difficulty adjusting to the burdens and restrictions associated with going public.

To participate in an IPO

Public offerings are primarily sold to institutional investors; however, some shares are also allocated to the syndicate’s retail investors.

As an RBC Direct Investing client, you can place an expression of interest using the IPO Centre. Because the available quantity of a new issue is limited, you may receive a fill, partial fill or no fill on your order.