Initial Public Offering (IPO)
An IPO is the first time a company offers its shares to the general public.
What Is an IPO?
- IPO - A company's first sale of stock to the public; transitions the company from private to public
- Proceeds: Go to the issuing company (primary market transaction)
- Registration: Must file a registration statement (Form S-1) with the Securities and Exchange Commission (SEC) under the Securities Act of 1933
- Underwriter: An investment bank (the managing underwriter) manages the offering
- IPO shares are sold in the primary market; subsequent trading occurs in the secondary market
Key Steps in an IPO
- Issuer selects a managing underwriter (lead investment banker)
- Due diligence is conducted on the issuer
- Registration statement (Form S-1) is filed with the SEC under the Securities Act of 1933
- SEC reviews the filing; a minimum 20-day cooling-off period begins
- During the cooling-off period, the preliminary prospectus (red herring) may be distributed to gauge investor interest
- SEC declares the registration effective (does NOT "approve" the offering)
- Final prospectus is delivered to investors at or before the time of sale
- Securities are priced and sold to investors
Exam Tip: Gotchas
- An IPO is a primary market transaction. Proceeds go to the issuing company, not selling shareholders.
- The SEC never "approves" an offering or passes judgment on the investment's quality. It only declares the registration statement "effective," meaning disclosure requirements have been met. An exam question saying the SEC "approved" a security is always wrong.
Cooling-Off Period
The cooling-off period is a minimum 20-day waiting period from the date the registration statement is filed with the SEC until it becomes effective.
- During this period: indications of interest may be collected, but NO binding sales or acceptance of payment
- The preliminary prospectus (red herring) may be distributed
- Tombstone ads (brief public notices) may also be published
- The SEC may issue a stop order to suspend effectiveness if material misstatements or omissions are found
Exam Tip: Gotchas
- Underwriters can collect indications of interest during the cooling-off period but cannot accept orders or money. No sales occur until the effective date.
- During the cooling-off period, only the preliminary prospectus and tombstone ads are permitted; no sales can occur.
Key IPO Documents
| Document | Purpose | When Used |
|---|---|---|
| Registration statement (S-1) | Full disclosure filing with the SEC | Filed before offering |
| Preliminary prospectus (red herring) | Shares material info with potential investors; lacks final price and effective date; has red-ink disclaimer on cover | During the cooling-off period |
| Final prospectus | Complete disclosure document with final price; must be delivered to all buyers | At or before time of sale |
| Tombstone ad | Brief public notice of the offering; contains only factual information (issuer name, security type, price, underwriter) | During or after the cooling-off period |
Exam Tip: Gotchas
- A tombstone ad is NOT a prospectus and NOT an offer to sell. It is merely a public announcement. It cannot contain recommendations or promotional language.
Key Parties in a Public Offering
- Managing underwriter (book runner): Leads the offering, forms the syndicate, sets pricing
- Syndicate members: Other broker-dealers that share underwriting risk and distribution
- Selling group: Firms that help sell the offering but do NOT take on underwriting risk
Underwriting Arrangements
| Type | Risk to Underwriter | How It Works |
|---|---|---|
| Firm commitment | High - underwriter buys entire issue | Underwriter purchases all shares at a discount (acts as principal); resells to public; bears risk of unsold shares |
| Best efforts | Low - no obligation to buy | Underwriter sells as much as possible (acts as agent); returns unsold shares to issuer |
| All-or-none | Conditional | A type of best efforts; entire issue must be sold or the offering is cancelled and funds returned |
| Mini-max | Conditional | A type of best efforts with a minimum sales threshold; if minimum met, offering proceeds; if not, cancelled |
Underwriting spread (gross spread): The difference between the price paid to the issuer and the public offering price; compensates the underwriters.
- Components: manager's fee + underwriting fee + selling concession
Exam Tip: Gotchas
- In a firm commitment, the underwriter acts as principal (dealer) - buying from the issuer and reselling to investors. In best efforts, the underwriter acts as agent (broker) - selling on behalf of the issuer without purchasing. The exam tests this principal vs. agent distinction.
Price Stabilization and Greenshoe Option
- Stabilization - The managing underwriter may place bids at or below the public offering price to prevent the stock from falling below the offering price in the aftermarket
- Only the managing underwriter may stabilize; must be at or below the offering price
- Greenshoe (overallotment) option - Allows the underwriter to sell up to 15% more shares than originally planned if demand is strong
- Named after Green Shoe Manufacturing, the first company to use this provision
Post-IPO Restrictions
- Lock-up period - Typically 90 to 180 days after the IPO during which insiders and early investors cannot sell their shares; contractual agreement between insiders and the underwriter (not regulatory)
- Quiet period - Restrictions on issuer and underwriter communications; extends 40 days after the IPO for research analysts at participating underwriters
Exam Tip: Gotchas
- Lock-up agreements are contractual between insiders and the underwriter, not SEC regulations. The SEC does not mandate lock-up periods.