An Initial Public Offering is essentially the beginning of a new stock. As the name implies, this is the first time that ownership in the company has been offered to the general public. Since the names covered here on Zachstocks are primarily companies that have recently issued their shares, and the fund that I manage focuses on stocks less than 5 years out from their IPOs, it seemed worthwhile to give a quick tutorial on just how one of these transactions takes place.

Most IPOs are companies that have been in business for a period of time already. There are two primary reasons a company might list shares on an exchange. The first primary reason is simply an exit strategy for the party who actually started the company in the first place. Imagine a group of doctors that developed a new treatment and built a company around making this treatment available to the public. After several years, the company is operating profitably and the doctors decide they want to sell a portion of their business to collect on the success from their hard work. In this case the group may contact an underwriter (I’ll explain this a bit later) to sell 40% of their ownership to the public. The doctors would receive the capital from the IPO and would essentially be paid back for their initial investment and hard work of building the company.

The second primary reason for listing a company would be to access additional capital for use within the company. Imagine the same group of doctors with a great treatment that has been proven to work, but in need of extra money to ramp up production of the equipment and distribute it to facilities across the nation. This company may sell partial ownership in an IPO transaction and thus raise $150 million dollars for working capital to build the business. If the firm is successful in growing, then the new investors who bought stock, as well as the doctors who still own a portion of the company, will participate in the profits.

In order to find enough buyers to make an IPO successful, most companies employ the services of an underwriter to market the shares. Underwriters are typically broker/dealers and the major players have recognizable names like Morgan Stanley, Merrill Lynch, Lehman Brothers, or Goldman Sachs. The underwriters typically perform due diligence to make sure they understand the business and that all of the financial records are in order. Then the underwriters reach out to their clients (institutional and individual investors) looking for potential buyers of the stock. Typically, there is a targeted date that the underwriter expects to actually sell the shares, and a range they expect to price the IPO at. My firm has relationships with many of the top underwriters so each week I receive multiple calls asking for indications of interest (IOI) for different offerings.

Once the underwriter has enough buyers lined up, the IPO is priced and the stock begins trading. If the deal is “tight” and there is plenty of interest in a name, then buyers may not get all the stock they asked for when giving their IOIs. Typically this would cause an IPO to trade higher as managers scramble to buy stock that they did not receive in the IPO transaction. Conversely, if the deal is “loose” then investors may have gotten all the stock they asked for in the deal and there is no additional demand to drive the price higher. This can lead to a stock moving sharply lower as there are an abundance of sellers but no additional buyers interested in picking up more shares.

The process is not perfect as many subjective decisions are made about which clients receive preferential treatment on deals. Good clients of the firm often have better access to hot IPOs as the shares are seen as a “thank you” for investors who have been loyal clients of the firm. It doesn’t make sense to give these choice shares to individuals who just show up asking for IPO stock but who don’t do any additional business with the firm. One of the most important tasks of an investment manager who trades IPOs is to keep a good relationship with multiple underwriters. Another benefit to these relationships is the fact that I am able to hear from multiple sources how a deal is shaping up and whether there is enough demand or not.

So the process of bringing a company is somewhat complicated, but definitely intriguing. It is part of the innovative system that makes this free market economy successful in the long term.

I hope this overview was helpful. Please comment and let me know if you would like to see more educational pieces on the weekends.

ZDS