Executive Summary
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The firm forms an underwriting syndicate by selecting a lead underwriter and co-managers. Typically, for small and medium-sized firms underwriters charge a fee of 7% of the issue value. In the United States, a firm registers with the Securities and Exchange Commission (SEC) for the IPO issue, and when it has received approval it distributes a preliminary prospectus, known as a “red herring,” to the public.
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The firm has to select an exchange on which to list its stock.
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The firm and the underwriter arrange road shows to promote the issue and to find out more about market demand; later this will provide useful information for setting the offer price and determining how many shares should be issued.
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After the IPO trading, the lead underwriter provides market research on the issue and other relevant information.
Why an IPO?
An initial public offering (IPO) of stocks is a share offering to the public by a small or medium-sized enterprise (SME) undertaken to raise additional cash for future growth or to enable existing stockholders to cash out by selling part of their holdings. Among other things, a successful IPO will provide a company with an objective valuation of its stock, create a good public image of the company—thus lowering its cost of borrowing—and provide it with a pool of publicly owned shares for future acquisitions of other companies. However, there are also drawbacks to being a public company, such as loss of freedom (including costly disclosure requirements and close monitoring by the public and government) and, if a takeover is threatened, potential loss of control.
Types of IPO
There are many types of IPO, illustrating the different management and owner compensation contracts in firms.
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The plain vanilla IPO is undertaken by a privately held company, mostly owned by management, who want to secure additional funding and determine the company’s fair market value.
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A venture capital-backed IPO refers to a company in which management has sold its shares to one or more groups of private investors in return for funding and advice. This provides an effective incentive scheme for venture capitalists to implement their exit strategy after they have successfully transformed a firm in which they invested so that it is financially viable in the market.
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In a reverse-leveraged buyout, the proceeds of the IPO are used to pay off the debt accumulated when a company was privatized after a previous listing on an exchange. This process enables owners who own majority shares to privatize their publicly trading firms, which are undervalued in the market, thus realizing financial gains after the public was informed of the high intrinsic value of the private firm.
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A spin-off IPO denotes the process whereby a large company carves out a stand-alone subsidiary and sells it to the public. A spin-off may also offer owners of the parent firm and hedge funds the opportunity to capitalize mispricing in both the subsidiary and parent if the market is not efficient enough. An interesting example in the United States was the spin-off of uBid by Creative Computers in 1998, which enabled arbitragers to capitalize the mispricing between the two listed companies.
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