The IPO Process
The first task of management is to select the underwriters who will be responsible for the new issue. This is done roughly three months before the IPO date. The underwriters provide the issuing firm with procedural and financial advice. Later they will buy the stock and then sell it to the public. The company, with the aid of lawyers, accountants, and underwriters, submits a registration statement to a regulatory body (such as the Securities and Exchange Commission (SEC) in the United States) for approval of the public offering. The registration statement is a detailed document about the company’s history, business, and future plans. Specifically, the SEC requires information on the details of the company (form S-1), its financial history (form S-2), and expected cash flows (form S-3). The company must be able to back up the information provided to the SEC.
In the United States, about six weeks prior to the IPO issue the SEC reviews and approves the content of the disclosure to the public; this becomes the preliminary prospectus and is also called the “red herring.” In December 2006, the SEC set new rules on what information must be included about a public company’s executive compensation, including the level of executive pay, the benchmark used, and what quantitative or qualitative methods are employed in determining that pay.1 The prospectus is a legal document describing the securities to be offered to participants and buyers. It is advised on and distributed by the underwriters, and provides information such as the types of stock to be issued, biographies of officers and directors with detailed information about their compensation, any litigation in place, and any other material information.
After publication of the prospectus the company, with the help of the underwriting syndicate, prepares for roadshows to meet potential investors—primarily institutional investors in major cities like New York, San Francisco, Boston, Chicago, and Los Angeles. Roadshows may sometimes be arranged for overseas investors. After the SEC approves registration of the IPO, the underwriters and the company will agree on the amount and price of the issue. On the day prior to the IPO issue the exact price of the shares to be issued is announced by the underwriter. After the IPO, the lead underwriter provides stock liquidity and research coverage.
The IPO date is followed by a “lockup” period, the duration of which varies across different issues and markets, but is in the region of 180 days for a typical issue. After this “insiders,” who include the underwriters, are allowed to sell their shares. Insiders may or may not hold on to stock they own, depending on their motives and objectives. However, the lockup period appears to exert no control on those who bought shares at the market-offered IPO price, although there are regulatory restrictions on the types of clients to whom the firm can sell stock.
Selection of Underwriters
The board of a firm planning to launch an IPO will first meet with potential candidates for underwriters among investment banks and then select the lead underwriter. The choice of underwriter is based on criteria that include: a preliminary valuation of the firm based on its financial information; and the characteristics of the underwriter, such as previous IPO experience, strengths and weaknesses, client network, research capabilities, and support for post-IPO issues. Discounted cash flow analysis and earnings multiples (such as the price/earnings ratio) are typically used to come up with the preliminary value of the company.
Citigroup was ranked first among underwriters in 2007, arranging $617.6 billion of offerings, and JPMorgan Chase was second with $554.1 billion. Deutsche Bank was ranked third and Merrill fourth in underwriting volume.2 Citigroup has been top of the list for the past eight years. As a result of the global recession that began in 2008 the underwriting volume has declined, while fees have increased.
Types of Underwriting
The management of the IPO firm selects the underwriters and decides on the type of underwriting it wants. There are two types of underwriting: firm commitment, and best efforts. If the underwriter enters a firm commitment with the company, the underwriter is confident about the issue and is willing to buy all the shares if there is insufficient demand. In a firm commitment offering, the underwriters will buy the IPO shares at a discount in the range 3.5–7.0% and then sell them on to the public at the full offer price.
In a best efforts case, the investment bank will only do as much as it reasonably can to sell the shares and will return unsold equity to the firm. This practice is common for less liquid securities. However, if there is excess demand, the bank will ask for a “greenshoe” option, allowing it to buy additional stock from the IPO firm. Typically, a lead underwriter asks other investment banks to form an underwriting syndicate to take care of the IPO issue before final approval by the SEC. The syndicate serves to expand the marketing of the company’s stock issue and to reduce the overall risk of the lead bank. The syndicate members are involved in the underwriting either through a commitment to sell the shares or just in marketing of the shares.
Underwriters may face legal consequences if a new issue goes wrong. Therefore, they have to present accurate and fair facts about the firm to investors, because otherwise they may be sued for misrepresentation, or for failing to carry out due diligence. Some underwriters may allocate stocks of popular new issues to their important corporate clients; this is known as “spinning,” and is deemed to be unethical and illegal.
Underwriters charge different spreads, and domestic and overseas spreads may differ. The average underwriting fee (spread) runs between about 3.3% and 7% in the United Kingdom and the United States (Brealey, Myers, and Allen, 2008).
Selection of an Exchange
Different exchanges have different listing requirements. In general, they require minimum levels of pretax income, net tangible assets, and number of stockholders. For example, a New York Stock Exchange listing requires an income of either US$2.5 million before federal income taxes for the most recent year or US$2 million pretax for the each of the preceding two years. The firm must have been profitable in the two years before a listing.
The NASDAQ (National Association of Securities Dealers Automated Quotations), the largest electronic screen-based equity securities trading market in the United States, has lower listing requirements than the NYSE. Other markets, such as the NASDAQ Small Cap Market and the American Stock Exchange, offer even lower listing requirements (www.inc.com/guides/finance/20713.html). Thus, an IPO firm needs to assess its own strengths and weaknesses in order to pick the right exchange on which to list its shares.
A firm also needs to select a trading symbol for use on the exchange. For example, Microsoft trades as MSFT. A fee, which varies for each exchange, has to be paid for the services provided.
IPO shares are distributed in different ways to investors. One approach is an open auction, where investors are invited to submit bids stating the number of shares they wish to purchase and the price they will pay for them. The highest bidders get the securities. The Google IPO of US$1.7 billion in 2004 and the Morningstar IPO of US$140 million in 2005 used this open auction method.
The bookbuilding method is the most commonly used in the United States today and is gaining popularity and dominance across the globe (Degeorge, Derrien, and Womack, 2007). During the roadshows, the investment banker asks institutional investors and individual clients about their intention to buy the shares. Each bid indicates the number to be purchased, and may include a limiting price. Such information is recorded in a “book,” from which the name bookbuilding is derived. These indications of interest provide valuable information, because all bids are compiled to ascertain the market demand for the security. Although these bid indications are not binding, the investment banker can utilize the information to set the final offer price, which is made known on the day before the actual issue (Cornelli and Goldreich, 2003).
The appeal of the bookbuilding method, despite its higher underwriting costs, is that investment banks provide better promotion and research coverage of the IPO than other IPO issuing procedures. Thus, the networking of the bank with clients helps to enhance the image of the issuing firm. Chief financial officers appear to prefer this approach to IPOs despite the higher cost.