How an IPO Works

When companies like Facebook go public, it’s big news. Just like the IPOs of Groupon (NASDAQ:GRPN), Zynga (NASDAQ:ZNGA) and LinkedIn (NYSE:LNKD) garnered attention, so has Facebook — in fact, much more so.

But it’s easy to get lost in the swarm of headlines. Since the dot-com boom, the IPO market has been relatively quiet, and many investors no longer understand the key aspects of IPOs. And IPOs also are surrounded by a complex set of regulations, many of which go all the way back to the Great Depression.

So before jumping into the world of IPOs, investors should brush up on the basics of public offerings. Doing so can provide a lot more insight for when a company’s stock finally hits the exchanges.

What is an IPO?

An IPO, or initial public offering, is when a private company lists shares on an exchange and sells them to public investors. The amount of capital raised is fixed, and the proceeds might either go directly to the firm, or part or even all might go to existing shareholders, like the founders, venture capitalists or private equity firms.

Investment Banking

A company that wants to go public will hire investment bankers — also known as underwriters — that will handle the IPO process. Some of the top firms for underwriting include Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS) and JPMorgan (NYSE:JPM).

The lead investment bank will conduct due diligence on the company before taking on the assignment. This involves an extensive investigation of the company’s books as well as interviews with employees, customers and partners.

Letter of Intent and the S-1

If the company passes the due diligence phase, the underwriter will submit a “letter of intent.” This will set forth the terms of the offering, such as the fees, valuation ranges and the amount to be raised.

Once the letter of intent is signed, the company will begin the process of drafting an extensive disclosure statement, called an S-1. This also is known as the prospectus or registration statement, and it contains the company’s business plan, executive compensation, audited financials and risk factors. It easily can take several months and often involves vigorous debate between the company and its attorneys, auditors and underwriter.

After the S-1 is finished, the company will submit it to the Securities and Exchange Commission, the federal agency that enforces the securities laws. It often will make various comments and ask questions about the document. Each will result in an amended S-1.

Getting the Deal Done

After filing the initial S-1, a company must abide by the “quiet period.” This means executives and major shareholders cannot make any public statements about the IPO. Again, the goal is to reduce any pre-deal hype, which could harm investors.

While this is going on, the lead underwriter will seek out investors for the offering. Because IPOs usually raise anywhere between $100 million to $200 million, these investors often are limited to large players, such as mutual funds, institutions, endowments and hedge funds.

To get the interest of the investors, the underwriter will set up a roadshow, which involves presentations by management. This process can take one to two weeks. If you want to check out a road show presentation, you can find the latest ones at

Through the process, the underwriter will get a sense of the overall demand for the IPO and set a price range (for example: $12 to $14 per share), as well as the number of shares that will be issued.

Ready to Trade!

When the SEC has no more comments or questions about the S-1, the offering will be declared “effective,” and the company will be able to offer its securities to the public.

On the night before the IPO, the company’s senior management team and the underwriter will have a meeting to set the final price of the offering. The final price usually will be somewhere near the original range, but considerations such as investor demand and return on money might alter the valuation — say, $15 after that original $12-$14 range. Often, the underwriter will try to undervalue the shares, which will create a “pop” on the first day of trading.

Because of the publicity — especially for high-profile IPOs — the trading can be substantial, say two to three times the number of shares issued, which means volatility can be significant.

Granted, an IPO can easily climb 20% or more on its first day of trading. However, only a small number of retail investors will get the IPO at the offering price. Thus, getting into a newly public company’s stock in the aftermarket — at least soon after the IPO — could mean suffering losses, a la LinkedIn and Pandora (NYSE:P).

Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “The Complete M&A Handbook”“All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli or reach him via email. As of this writing, he did not own a position in any of the aforementioned securities.

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