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In The KnowHow IPOs Work and What Can Go Wrong

By John Jagerson, Learning Markets Analyst1

It is common to read headlines that announce hugely successful IPO's: “Protolabs Rises 81% on First Day of Trading.” “Guidewire Jumps 32% on Day of IPO.” “Yelp Shares Close Out Opening Day Up 64%.” But are those results typical or the exception? Why do investors buy stock during an IPO and can anyone do it? Those are important questions for investors to consider the next time a hot stock gets ready to go public.

What is an IPO and how does it work?

An Initial Public Offering (IPO) is the process through which a private company raises capital by listing its shares on an exchange and sells them to public investors. The first day of public trading is the part everyone hears about but it is the last stage in this process. Understanding the steps that come prior is important if you plan to invest in an IPO, either directly in the offering or when the shares first begin trading, and to appreciate the risks associated with it. Successful IPOs get plenty of media attention but there are also a number of ways in which things can go wrong.

Going Public

Going public is one avenue that a private company has to raise needed capital. Its biggest advantage over other ways of raising capital (such as using debt or private equity) is that it allows the company and its existing shareholders to access highly liquid markets, usually by being listed on the NYSE or Nasdaq stock exchanges.

The company starts the process by hiring an investment bank, also called an “underwriter” when pursuing an IPO. Since the company has a defined amount of capital it seeks to raise, the investment bank guarantees to buy all of the shares being issued in the IPO, thereby assuring that the company's financing needs are met. The investment bank performs due diligence for a period of time to determine a range of fair market value for the company.

Larger IPO's are often brought to market by a group of investment banks, together called a “syndicate”, to spread the risk and broaden the pool of investors with whom to place stock. The lead underwriter takes the majority position and has the responsibility for placing most of the stock.

Letter of Intent and S-1

The underwriting firm will issue a letter of intent once the due diligence process is completed. This outlines the terms of the IPO deal: estimate of the company's value, range of the offering price per share, amount of money to be raised, fees, number of shares to be issued, etc. It is typical for investment banks to receive 6-7% of the gross proceeds raised in the offering, although these fees decline for larger deals.

If the company agrees to the terms in the letter of intent, it begins preparing an in-depth disclosure statement called the S-1. This is the IPO's prospectus as well as the registration document that gets filed with the SEC in preparation to offer securities to the public. It is designed to be a deep-dive into the company's financial condition and to provide as much information as possible to prospective investors about their business model.

Selling the Deal, Setting the Price

Once the S-1 is filed with the SEC, the underwriting firm begins “selling” the company and weighing market demand in order to set an appropriate range for the IPO price (for example, $14 - $16). The lead underwriter usually conducts a roadshow, taking company executives around the country to make presentations to their institutional clients. During this time, investors put in indications of interest to signal how many shares they are interested in buying. This is called subscribing to the deal and, although it is non-binding, it helps the investment bank determine the proper price for the stock. If it is a hot deal (meaning it is oversubscribed), the bank may raise the offering price to better match demand. If it is undersubscribed, they may drop the price range to stimulate more demand or cancel the IPO altogether.

IPO is Finalized

The SEC obviously has to green light the offering before the company can begin trading on an exchange. When the company first submits its S-1 to the SEC, there is often a back-and-forth exchange as the SEC asks questions and seeks clarification about the company's financials, business plan, and risk disclosures. Once these issues are settled, the offering becomes effective and the company is then able to sell its shares publicly.

In the closing days before the IPO, final details of the offering are settled: the IPO price is finalized based on subscription demand and client orders are confirmed. The investment bank purchases all of the shares from the company and then allocates the subscribed shares to client accounts. Since the investment bank (or group of banks) will initially be the only market makers when the shares go public, they also keep a portion of shares for themselves.

Technically then, the initial public offering happens before the shares are released for trading on the exchanges. When the stock is allocated to the underwriting firm's clients, this is the initial public offering – and it is also why it can be very difficult to participate directly in popular IPOs. Since investment banks need to place a substantial amount of shares, they turn to their institutional clients to do so. In the traditional IPO process, you must first be a client of the underwriting firm in order to have the possibility of being allocated IPO stock.

Investment banks often use highly anticipated IPOs to reward clients that do a lot of business with them. Retail clients can find it difficult to move up on this priority list, although it is still possible for small investors to receive shares. Typically, however, it is an individual investor's financial advisor who decides whether or not she will put in for IPO stock on your behalf. However, the more popular the IPO, the more difficult it can be to be participate.

IPOs attract investor attention because a) they involve companies that are in a strong growth phase, almost by definition, and b) they usually occur during bull markets when private companies and underwriters have confidence that there will be robust demand for their shares. For this reason, financial research has shown that about 75% of IPOs increase in price on the first day of trading, 9% remain at their offering price, while only 16% fall.

However, even with a growing company that goes public in a bullish market things can still go wrong with an IPO.

How to Fumble One of the Most Anticipated IPOs in History

In setting the IPO price, the investment bank attempts to strike a balance between the needs of the company going public, their clients, themselves, and the appetite within the market. If the offering price is set too low, their clients may be happy but the bank may not fully cover the risk taken in financing the deal. Set the price too high and the firm will have upset clients who feel that they overpaid for the stock. It also damages the reputation of the bank and the new public company as well. A company whose stock price falls below its IPO level is often perceived as company in trouble.

So misreading this initial demand can have big consequences. When Facebook (FB) first went public on May 18th 2012, it was one of the most hyped and eagerly awaited IPOs in recent history. Morgan Stanley (MS), as lead underwriter, was responsible for determining the appropriate offering price. This was no straightforward task as the deal came with a lot of challenges, from Facebook's revenue model, to a CEO whose priorities were not always aligned with those of Wall Street. The fact that the company was seeking to raise $5-10 billion, making it one of the largest IPOs in the history of tech companies, didn't help simplify matters. In many ways this was a deal that staked out uncharted territory.

In early May, MS set a range of $28 to $35 per share, putting a valuation on Facebook of $77 to $96 billion. As anticipation continued to build, investor interest revealed that the deal was highly oversubscribed and prompted MS to raise the offering price to $34 to $38. Many commentators and analysts at the time suggested that the deal could be priced as high as $40 or even $50. Two days before the shares were set to start trading, FB announced it would sell 25% more shares than initially planned and MS set the offering price at $38, putting FB's initial valuation at over $100 billion, the highest market cap for an IPO in history.

On the first day of trading, despite projections that the stock could double, FB closed the session at only $38.23, $0.23 above its offering price. And in hindsight, that was the good news: this was the highest closing price the company has seen since. Within less than a month, the stock was trading under $27 and by early September 2012 it had fallen below $18. FB's ungracious fall prompted harsh criticism all the way around, of the Nasdaq for technical glitches, of CNBC for overhyping the deal, of FB itself for getting greedy at trying to set new benchmarks as a IPO. But much of the blame focused on MS for issuing too much stock and setting the offering price too high.

Although an onslaught of lawsuits has followed in the wake of the disappointing offering, the situation illustrates that IPO's have inherent risks commensurate with the potential rewards. Investors participating in an IPO, no matter how popular, are not guaranteed a handsome profit or an immediate pop on the first day of trading. These opportunities require just as much diligence and discipline as any other investment decision and investors should understand how to react when an IPO does not perform as planned.

1This content was created and is being presented by an independent party not employed by or affiliated with Scottrade or its affiliates. Scottrade, Inc. and its affiliates have not created and are not responsible for such materials. The content of such materials has not been adopted, endorsed or approved by Scottrade or its affiliates and does not reflect the opinion, belief or recommendation of Scottrade.

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