In an IPO, the issuer may obtain the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), best offering price and time to bring it to market.
IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock or shares will do on its initial day of trading and in the near future since there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, and they are therefore subject to additional uncertainty regarding their future value.
The existing shareholders will see their shareholdings diluted as a proportion of the company's shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms.
In addition, once a company is listed, it will be able to issue further shares via a rights issue, thereby again providing itself with capital for expansion without incurring any debt. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list.
The sale (that is, the allocation and pricing) of shares in an IPO may take several forms. Common methods include:
A large IPO is usually underwritten by a "syndicate" of investment banks led by one or more major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares sold. Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases. Multinational IPOs may have as many as three syndicates to deal with differing legal requirements in both the issuer's domestic market and other regions. For example, an issuer based in the E.U. may be represented by the main selling syndicate in its domestic market, Europe, in addition to separate syndicates or selling groups for US/Canada and for Asia. Usually, the lead underwriter in the main selling group is also the lead bank in the other selling groups.
Because of the wide array of legal requirements, IPOs typically involve one or more law firms with major practices in securities law, such as the Magic Circle firms of London and the white shoe firms of New York City.
Usually, the offering will include the issuance of new shares, intended to raise new capital, as well the secondary sale of existing shares. However, certain regulatory restrictions and restrictions imposed by the lead underwriter are often placed on the sale of existing shares.
Public offerings are primarily sold to institutional investors, but some shares are also allocated to the underwriters' retail investors. A broker selling shares of a public offering to his clients is paid through a sales credit instead of a commission. The client pays no commission to purchase the shares of a public offering; the purchase price simply includes the built-in sales credit.
The issuer usually allows the underwriters an option to increase the size of the offering by up to 15% under certain circumstance known as the greenshoe or overallotment option.
Initial founders could often become overnight millionaires, and due to generous stock options, employees could make a great deal of money as well. The majority of IPOs could be found on the Nasdaq stock exchange, which lists companies related to computer and information technology. However, in spite of the large amounts of financial resources made available to relatively young and untested firms (often in multiple rounds of financing), the vast majority of them rapidly entered cash crisis. Crisis was particularly likely in the case of firms where the founding team liquidated a substantial portion of their stake in the firm at or soon after the IPO (Mudambi and Treichel, 2005).
This phenomenon was not limited to the United States. In Japan, for example, a similar situation occurred. Some companies were operated in a similar way in that their only goal was to have an IPO. Some stock exchanges were set up for those companies, such as Nasdaq Japan.
Perhaps the clearest bubbles in the history of hot IPO markets were in 1929, when closed-end fund IPOs sold at enormous premiums to net asset value, and in 1989, when closed-end country fund IPOs sold at enormous premiums to net asset value. What makes these bubbles so clear is the ability to compare market prices for shares in the closed-end funds to the value of the shares in the funds' portfolios. When market prices are multiples of the underlying value, bubbles are occurring.
The danger of overpricing is also an important consideration. If a stock is offered to the public at a higher price than the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value.
Investment banks, therefore, take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company. The process of determining an optimal price usually involves the underwriters ("syndicate") arranging share purchase commitments from lead institutional investors.
A company that is planning an IPO appoints lead managers to help it decide on an appropriate price at which the shares should be issued. There are two ways in which the price of an IPO can be determined: either the company, with the help of its lead managers, fixes a price or the price is arrived at through the process of book building.
Note: Not all IPOs are eligible for delivery settlement through the DTC system, which would then either require the physical delivery of the stock certificates to the clearing agent bank's custodian, or a delivery versus payment ("DVP") arrangement with the selling group brokerage firm. This information is not sufficient.
The other "quiet period" refers to a period of 40 calendar days following an IPO's first day of public trading. During this time, insiders and any underwriters involved in the IPO, are restricted from issuing any earnings forecasts or research reports for the company. Regulatory changes enacted by the SEC as part of the Global Settlement, enlarged the "quiet period" from 25 days to 40 days on July 9, 2002. When the quiet period is over, generally the lead underwriters will initiate research coverage on the firm. Additionally, the NASD and NYSE have approved a rule mandating a 10-day quiet period after a Secondary Offering and a 15-day quiet period both before and after expiration of a "lock-up agreement" for a securities offering.