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What Is An IPO?

What Is An IPO?An Initial Public Offering (IPO) is a private company’s first public sale of stock, designed to raise capital by the sale of stock and/or to “go public.” An IPO is merely one method of raising capital and the decision of whether to use an IPO is based on many success factors. One factor is the risk and expense associated with an IPO: the company must decide whether it can use another alternative, such as a joint venture or a business alliance, which can achieve the same result without all the risks and expenses of an IPO. Even if a company decides to use an IPO, there are a number of factors to consider: the “debt-to-equity” ratio is used by investors to look for a company that is well-funded and that may be refinancing or otherwise lowering its indebtedness before the IPO; the company’s individual qualities, such as management, business strategy, brand and position in the market are other factors; timing and the way in which the IPO will be run are other factors. Success factors inside and outside the company all make a difference in the company’s decisions of whether to use an IPO, what type of IPO should be used, and how that IPO will be accomplished.

If a company decides to use an IPO to raise capital, several basic steps will be followed.

First, the company will file an S1 Registration Statement and prospectus that gives company information to the Securities and Exchange Commission (SEC) and investors. Secondly, the SEC will review of the documents and direct the company to correct the documents if they are inaccurate or do not follow the rules. Third, if/when the documents are accurate and compliant; the SEC will issue an order stating that the Statement is effective. Fourth, the company will develop either a traditional IPO or an auction-based IPO.

Companies choose traditional or online auction IPOs based on several pros and cons of each approach. A traditional IPO, used by Facebook, Inc., for example, is more established and accepted by traditionally large investors like investment banks and wealthy Wall Street investors, so there is less financial risk in the traditional IPO than in an online auction. A traditional IPO uses underwriters who examine the market for “indications of interest” to set the number and price of shares. Being more established, traditional IPOs can receive widespread favorable media coverage that would give traditional large investors more confidence about investing in the IPO and can raise great sums of money from relatively few investors. On the downside, traditional IPOs can be complex and expensive, involving multiple underwriters and managers with high IPO fees such as: selling concessions of 50-60% of the spread, underwriters’ fees of 20-30% of the spread, managers’ fees of 10-20% of the spread, SEC fees assessed per each $1 million and SEC assessments on security futures transactions per round turn. An online auction IPO, used by Google, Inc., for example, “spreads the wealth” more democratically by attracting many small investors. If the company uses the auction method: it still uses an underwriter but there is no share allocation; the company sets the stock price higher than any bid it expects; potential investors bid for the number of shares and price; bidders keep bidding in increments until they reach a bid that all bidders must pay. While the auction method avoids some traditional IPO problems and costs, they still must pay the lower fees and costs of an online auction IPO, still must hire a bank, set the number of shares, set the price per share and pay fees to the SEC. Furthermore, an auction IPO forfeits some potential benefits of a traditional IPO: they do not tend to receive as much positive media attention as do traditional IPOs; there tends to be more financial risk in reliance on the bids of many small investors; and the amount obtained from those many small investors may well be less than could be raised by a much smaller number of very large investors such as investment banks and hedge funds. Consequently, despite the traditional IPO’s greater complication, number of people and institutions controlling the IPO and greater fees, traditional IPOs are used more often because the financial return tends to be worth the trouble.

Perhaps the most notorious recent example of a traditional IPO is that of Facebook, Inc. Facebook, Inc. is a social networking company that engaged in a simultaneously successful and flawed IPO resulting in multiple lawsuits against the company and its underwriters. Though the IPO traded on huge volume and raised $16 billion, it also reportedly resulted in the loss of $billions to investors due to stock overvaluation and supposed mismanagement. Due to these successes and failures, Facebook, Inc.’s IPO is a success story but also a cautionary tale. Facebook, Inc. filed its S1 Form Registration Statement and Consolidated Balance Sheet with the SEC on February 1, 2012, with Morgan Stanley, J.P. Morgan and Goldman, Sachs & Co as the underwriters. The IPO was intended to raise $5 billion with public trading of 421 million shares of stock at $28 – $35 per share, starting on May 18, 2012. However, there was so much hype and excitement about the IPO that when it began to trade, it first rose to $45/share. By the end of the day, the stock was valued at $38.23 per share, though it traded on volume of 460 million shares and raised $16 billion. After that day, the stock kept sinking until it was only $27.10/share on June 6, 2012, costing investors billions and resulting in many lawsuits against Facebook and its underwriters. In sum, Facebook, Inc.’s IPO was both a great success in raising more than 3 times its intended capital and an apparent failure in other respects, costing billions of dollars to investors and resulting in multiple lawsuits.

Kathy Catanzarite

[Note from HandelontheLaw.com: This article is to be used as an educational guide only and should not be interpreted as a legal consultation. Readers of this article are advised to seek an attorney if a legal consultation is needed. Laws may vary by state and are subject to change, thus the accuracy of this information cannot be guaranteed. Readers act on this information solely at their own risk. Neither HandelontheLaw.com, or any of its affiliates, shall have any liability stemming from this article.]