An Initial Public Offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. The public issuance of shares allows a company to obtain capital from public investors.
The transition from a private to public company can be an important moment for private investors to realize profits from their investment, as it typically includes issuance premiums for current private investors. Meanwhile, it also allows public investors to participate in the offering.
Before an IPO, a company is considered private. As a private company, the business has grown with a relatively small number of shareholders, including early investors such as founders, family, and friends, along with professional investors such as venture capitalists or angel investors.
When a company reaches a stage in its growth process in which it believes it is mature enough for the rigors of the regulator, the U.S. Securities and Exchange Commission (SEC), along with the benefits and responsibilities for public shareholders, will begin to advertise its interest in going public.
An IPO is a big step for a company as it provides access to raising a lot of money. This gives the company greater capacity to grow and expand. The increased transparency and credibility of stock listing may also be a factor in helping it secure better terms when seeking investment.
When a company goes public, the previously privately owned shares of ownership become public, and the shares of existing private shareholders are worth the public listing price.
Meanwhile, the public market opens a great opportunity for millions of investors to purchase company shares and contribute capital to the company's equity. The public is made up of any individual or institutional investor interested in investing in the company and possibly making the investment part of their long-term compounding interest strategy.
Subscribers and the Initial Public Offering Process
An IPO consists of a pre-marketing phase of the offering, while the second is the IPO itself.
When a company is interested in an IPO, it will be announced to subscribing companies (commonly led by investment banks) requesting private bids or it can also make a public statement to generate interest. Investment banks (subscribers) lead the IPO process and are chosen by the company.
A company can choose one or several subscribers to manage different parts of the IPO process collaboratively. Subscribers are involved in all aspects of IPO due diligence, document preparation, filing, marketing, and issuance, accordingly, it is a long and costly process.
Investment banks charge subscription fees as they take a company public. Subscription fees are the largest direct cost associated with an IPO. According to public filings from 829 companies, costs for companies range on average from 3.5% to 7.0% of gross IPO proceeds.
The Initial Public Offering (IPO) Lock-Up Period
It is a contractual provision that prevents insiders who already own shares from selling them for a certain period of time after the IPO. The standard lock-up period generally ranges from 90 to 180 days. The main objective of an IPO lock-up period is to prevent large investors from flooding the market with shares.
The most recent case of an IPO lock-up expiration was in February 2021, when Palantir (NYSE: PLRT) declared its first earnings report as a public company.
On that date, the lock-up period expired, and Palantir's largest shareholders were able to sell 80% of their stakes, releasing the supply of shares to the market, causing an estimated drop of at least 10% in the stock value in the following weeks, as shown in the chart above.
Disadvantages of the IPOs
Companies may face several disadvantages when going public and potentially choose alternative strategies.
Some of the main disadvantages include the following:
An IPO is expensive, and the costs associated with maintaining a public company are ongoing and typically unrelated to other business costs. The company is required to disclose financial, accounting, tax, and other business information. During these disclosures, it may be necessary to publicly reveal secrets and trade secrets that could assist competitors.
There are significant legal, accounting, and marketing costs, many of which persist over time. It requires more time, effort, and attention from management for reporting. There is a risk of not raising the necessary funding if the market does not accept the IPO price.
There is a loss of control and stronger agency problems due to new shareholders who gain voting rights and can effectively control company decisions through the board of directors. There is a higher risk of legal or regulatory issues, such as private securities class actions and shareholder suits.
Fluctuations in a company's stock price can be a distraction for management, which may be compensated and evaluated based on stock performance rather than actual financial results. Strategies used to inflate the value of a public company's stock, such as excessive debt used to buy back shares, can increase risk and instability for the company.
Leadership and governance governed by the board of directors can make it difficult to retain good managers willing to take risks.
For all the reasons mentioned above, being a public company requires significant efforts, expenses, and risks that a company may decide not to take. Maintaining privacy is always an option.
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