For a number of reasons, the chances of the average investor getting IPO shares before they begin trading is remote. That doesn’t mean however that there’s no opportunity to profit from them, if you understand how they work and what is available.
Who Determines an IPO Price?
Companies go public for two reasons: raising capital and unlocking existing shareholder value, which means gains for those who held pre-IPO shares. Companies that have been successful in their market and have built brand awareness then use the proceeds to make capital investments and acquisitions to drive growth and earnings. Existing shareholders can sell some or all of their holdings to a ready market. When companies are considering going public, they typically hire an investment bank to advise them and guide them through the lengthy and costly process. Investment bankers play another important role in the IPO process: underwriting. What happens during the underwriting process is that an investment bank—in this case serving as the underwriter—buys some or all IPO shares to ensure its success. There are a number of ways that investment bankers approach pricing, depending on the type of deal they have struck with the company that’s going public.
Firm Commitment
IPOs are often firm commitment deals where the investment bank commits to purchasing all of the initial offering shares from the company (issuer) at an agreed-upon price. Because the bankers are committed to purchasing all of the shares, they want to be sure investors will fully subscribe to the offering. The bankers are compensated by the issuer as a percentage of the gross proceeds, commonly referred to as the spread. The average spread for IPOs between 1980 and 2020 was about 5.5% of gross proceeds.
Best Efforts
Under the best efforts arrangement, the investment bank agrees to sell as many shares as possible. Unlike firm commitment, the underwriter has an option, not an obligation, to purchase the shares from the company and has the authority to sell them to investors. The bankers must sell a minimum number of shares, otherwise the offering is canceled, and the issuer pays no fees.
Auction
A public bidding process is used to determine the offering price. All interested investors are given the opportunity to bid on shares prior to the IPO. This process limits the role of investment bankers, making auction IPO fees generally lower than firm commitment or best efforts. The most notable auction IPO was Google in 2004. While there were 28 underwriters involved in this offering, given that buyers were found through the auction process, the underwriting fees were almost half compared to other IPOs.
Direct Listing
Shares are offered directly to investors by the issuer on the first day of trading. In a direct listing, share price is determined by demand and supply of shares in the market. Underwriters are not involved in the sales process. The cryptocurrency exchange Coinbase went public using a direct listing in April 2021.
The Process of Pricing an IPO
There are a number of steps involved in the price-discovery process of a traditional IPO where the investment bankers decide on the IPO price.
Preliminary Pricing
The pricing process begins with an extensive analysis of the company to prepare the registration statement to the Securities and Exchange Commission (SEC). Part I of the registration statement is the prospectus, which contains information investors need to know about the business, the offering, and the management. Part II contains supplemental information for the SEC about the offering, such as expenses and fees. There are many teams involved in the process. The issuer’s legal team, for example, prepares the statement and communicates with the SEC. The accounting team prepares and audits the issuer’s financial statements to be included. The investment banking team will research the financials, the market and the issuer’s position in it, corporate strategy, and comparable companies. Models are created to project the impact of additional capital funding on the size, scope, and earnings of the business.
Promoting The Offering
Once the registration statement is filed, the investment banking team begins book building. Book building is the process of promoting the offering to the market, and gathering nonbinding bids for the shares. This is a large part of a successful offering because it provides feedback from the market about the share price. Book building begins with a series of roadshows that help to promote the offering and create enthusiasm. Road shows can include conference calls with multiple investors, in-person meetings, and the publication of materials on the internet about the issuer’s business and the offering. There are question-and-answer sessions at each roadshow, giving investors insight into the management strategy and future potential of the business. The most important roadshows, however, are face-to-face meetings with the investment bank’s network of institutional and large investors. These face-to-face meetings give important investors the opportunity to interact directly with the CEO, CFO, and other senior managers.
Final Offer Price
Bankers use the indications of interest and response to the roadshows to arrive at a final price for the offering. The legal team files a request with the SEC for an effective date of the registration, and the board of directors then approves the offering price. Once the SEC deems the registration effective, shares are allocated to investors at the final offer price. Trading on the exchange begins on listing day.
Offer Price Vs. Opening Price
The offer price determines how much money the issuer is paid for the shares, whereas the opening price on the exchange represents what the broad market of all investors is willing to pay for shares. The investment banking team has to balance the two most important and conflicting parts of their role: In representing the issuer, they have an obligation to get the highest share price they can for the offering. At the same time, though, they want to make the price attractive enough for investors to purchase all of the shares.
Why It Matters to Individual Investors
Investment banks sometimes allocate shares to broker-dealers with retail clients. If your broker-dealer does have an allocation, they may only offer them to clients with large accounts. For most investors, access to IPO shares is extremely limited. All investors, however, can purchase shares once they begin trading. Share price can also sharply increase because of a limited supply of shares available in the market following the IPO. Shares of existing shareholders may not be available for six months due to “lock up” restrictions. Investment banks also restrict the supply of shares by discouraging “flipping”. Flipping is selling IPO shares in the market right away. Investment banks discourage the practice by not giving allocations to clients that have flipped shares in the past. Another way to invest is to purchase shares of an IPO Exchange Traded Fund (ETF). IPO ETFs, such as First Trust US Equity Opportunities ETF (FPX), tracks IPOX-100 U.S. (an applied market cap-weighted index portfolio), and invests in companies that have recently gone public. The advantage of using an ETF is investing in many IPO companies for a relatively small amount of money. Finally, as of December 2020, companies can use direct listings to raise capital by issuing new shares. Direct listings may offer more IPO opportunities for small investors in the future. The decision to invest in IPO companies, like all other investments, should be based on your financial goals, time horizon, and risk tolerance.
