What is an Initial Public Offering? – Accounting Superpowers

What is an Initial Public Offering?

Initial Public Offering 

An Initial Public Offering (also called an IPO) is the process in which a privately held company makes it shares available for sale to the public.  Companies use the IPO process to raise capital for expansion and future growth.

For many Entrepreneurs, the Initial Public Offering is done for reasons that go beyond the monetary and is considered the ultimate mark of success. 

One that is accompanied by public acknowledgment of the years of hard work that went into building the company as well as a large payout.

History of the IPO 

Go to any major city across the globe and your bound to find some of the same brands across town. You'll see the same clothing stores (think GAP), restaurants (think McDonald's), and gas stations (think Shell). 

But have you ever thought about why these companies have been able to leapfrog the average business and become such global powerhouses?

I'm gonna give you a brief history lesson and you'll be able to see a common thread that binds the companies that make it really big.  

In the 1600s, there was a company called the Dutch East India Company or the VOC (Vereenigde Oost-Indische Compagnie) that wanted to trade Gold, Spices, and Silks around the globe. 

But running expeditions was a very high-risk venture, not only because of the financial risk, but also the dangers of piracy, disease, and shipwrecks. 

Acknowledging the risks and sensing the enormity of financial capital required to make their company successful, the VOC devised an ingenious solution to raise money. 

In the center of Amsterdam, the VOC built a trading house where every Dutch citizen could go and buy shares of the company effectively giving the company money now in exchange for a claim on the profits in the future.  

Pretty much every rich man in the Netherlands invested in the VOC and even some immigrants did so. 

Leveraging the financial capital gained from these investors, the VOC commanded almost 5,000 ships over its lifetime and enjoyed huge profits from its trading activities also making Amsterdam the financial center of the world at the time. 

Unbeknownst to them, the VOC had effectively launched the world's first IPO and created the world's first stock market by being the first publicly-traded company in history.  

Fast forward to modern times. 

The concept behind an IPO remains the same.  

How does an Initial Public Offering work?

When a company decides to go public, the process begins with interviewing Investment Banks with expertise in the field. 

After a series of initial interviews, bankers place 'bids' for the company's business. In the bids, Investment Banks will highlight their strengths and why they would be the best fit to meet the client's requirements. 

Investing Speak

Companies interview several investment banks to determine which one will lead the IPO process. In the Financial industry, these situations in which two or more investment banks compete to attract a client's business is often referred to as a “bake-off.” 

While the bid is an important component, companies consider a range of other factors such as capable team, experience, track record, etc. and choose the bank who is the best fit to move forward. Because of the size and complexity of some deals, companies may also hire more than one investment bank. 

The Investment Bankers now begin the due diligence process and hold a series or meetings with the company to prepare a preliminary prospectus.  This is the initial stage of the IPO process.  

Investing Speak!

The Preliminary prospectus is also referred to as the 'Red Herring' because it has a standard legal disclaimer printed in red across its cover, stating that the securities are not yet being offered.

The preliminary prospectus lists the history, management experience, opportunities, risks, strategy, and financial details about the company. 

The goal of this stage is two-fold. First, to see if there is enough interest from Investors to move forward and to establish a price range for the eventual stock issue.  

As progress is made, the roadshow begins. Roadshows are marketing techniques that Investment Banks use to drum up interest for the offering while keeping in mind that all information being presented is factual. During the roadshow process, multiple presentations are made. These presentations may be made "one-on-one" with the most important Investors as well as be made to larger groups of Investors throughout the country. The roadshow also gives the opportunity to Investors to get to know management and ask pertinent questions about the proposed Investment.    

As the process moves along, non-binding offers are accepted and a 'book' is built. With enough interest, further steps are taken to establish a retail price. The retail price of the stock is determined largely based on the feedback and sentiment of the Initial Investors.      

The completion of the roadshow is followed by the issuance of the final prospectus. The prospectus is also filed with the SEC and includes all the details mentioned in the initial prospectus plus more such as Quantity, Price, and date of the IPO.  

After the IPO is approved by the SEC, the effective date is decided. Once the shares have been made public, the stock is now open to all in the market and allows folks like you and me to get a piece of the action.

Why don't most businesses go public? 

With access to so much capital, you may not be wrong in thinking, why don't most companies do this? 

While it is true that going public can give a company access to an entire world of expansion and investment opportunities, what you must keep in mind is that taking a company public involves a BIG trade off.   

While it allows a private company access to substantially more capital than they can get through private shareholders or venture capitalists in exchange for a stake in company ownership, the process is public is not easy and the has extremely stringent government requirements during and after the IPO process. 

An IPO is not something that can be accomplished by the typical small business owner (think your local mom and pops retail shop). As an example, The median initial public offering (IPO) in the United States was 108 million U.S. dollars in 2019. 


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