Initial Public Offering (IPO)
An IPO is the most common way a private company becomes publicly traded. Understanding the process, the different underwriting commitments, and what happens after the offering is essential for the exam.
What Is an IPO?
- Initial Public Offering (IPO): The first sale of a company's stock to the public
- Transforms a private company into a publicly traded company
- The company (the issuer) receives the proceeds; this is a primary offering
- The issuer must register the offering with the Securities and Exchange Commission (SEC) before shares can be sold
Why companies go public:
- Raise capital for growth, acquisitions, or debt repayment
- Provide liquidity for early investors and founders
- Increase visibility and credibility in the marketplace
The Underwriting Process
Underwriters (investment banks) manage the IPO process from start to finish:
- Due diligence - Investigate the company's financials, operations, and risks
- SEC registration - File the registration statement (Form S-1)
- Pricing - Determine the offering price based on demand and valuation
- Distribution - Sell shares to investors through a syndicate of broker-dealers
Exam Tip: Gotchas
The underwriter sets the offering price before trading begins, but the market price on day one can be very different. If the exam asks who determines the IPO offering price, the answer is the underwriter (in consultation with the issuer), not the market or the SEC.
Types of Underwriting Commitments
The type of underwriting agreement determines who bears the risk of unsold shares. This is a high-frequency exam topic.
| Type | Who Bears Risk | How It Works |
|---|---|---|
| Firm commitment | Underwriter | Underwriter buys all shares from the issuer and resells to the public |
| Best efforts | Issuer | Underwriter sells as many shares as possible; unsold shares returned to issuer |
| All-or-none | Issuer | Entire issue must sell or the offering is canceled; investor funds held in escrow |
| Mini-maxi | Issuer | Sets a minimum and maximum; offering canceled if minimum not met |
| Standby | Underwriter | Used in rights offerings; underwriter buys any shares not purchased by existing shareholders |
Memory Aid:
- Firm = firm guarantee (underwriter buys all, bears the risk)
- Best efforts = best try (underwriter sells what it can, issuer bears the risk)
- All-or-none = all or cancel (a type of best efforts with 100% threshold)
Think of it this way: In a firm commitment, the underwriter acts like a wholesale buyer, purchasing the entire inventory and taking on the risk of reselling it. In best efforts, the underwriter acts like a consignment shop, selling what it can but returning what it cannot.
Firm Commitment (Most Common for IPOs)
- The underwriter purchases the entire issue from the company at a discount (the "spread")
- The underwriter then resells to the public at the offering price
- Risk shifts to the underwriter - if shares don't sell, the underwriter absorbs the loss
- The issuer knows exactly how much money it will receive before the offering begins
Best Efforts
- The underwriter acts as an agent, not a buyer
- Sells as many shares as possible but makes no guarantee
- Unsold shares are returned to the issuer
- The issuer bears the risk of not raising the full amount
All-or-None
- A variation of best efforts underwriting
- The entire issue must be sold or the offering is canceled
- Investor funds are held in escrow during the selling period
- If all shares sell, proceeds are released to the issuer
- If not all shares sell, investor money is returned
Exam Tip: Gotchas
All-or-none is a type of best efforts underwriting, not firm commitment. The underwriter does not buy the shares; the deal simply requires 100% subscription or it's canceled. This is often confused with firm commitment because the outcome sounds like "all or nothing," but the underwriter has no obligation to purchase shares.
Lock-Up Period
- Lock-up period: A contractual restriction preventing insiders from selling their shares for a set period after the IPO
- Typically 90-180 days (180 days is the most common)
- Applies to officers, directors, employees, and early investors
- Not an SEC rule - it's a contractual agreement between insiders and the underwriter
- Purpose: prevents a flood of insider selling that could tank the stock price immediately after the IPO
Think of it this way: The lock-up period is like a cooling-off period for insiders. Without it, founders and early investors could sell millions of shares the day after the IPO, flooding the market and crashing the price for new investors.
What happens when the lock-up expires:
- Insiders can sell their shares on the open market
- Often causes temporary downward pressure on the stock price as supply increases
Exam Tip: Gotchas
The lock-up period is an agreement between insiders and the underwriter, not a government regulation. Financial Industry Regulatory Authority (FINRA) Rule 5110 does require a 180-day lock-up on underwriter compensation securities, but the insider lock-up is contractual.
IPO Pricing and First-Day Trading
- IPO pricing is uncertain - the offering price is set before trading begins, but the market may disagree
- First-day trading can be highly volatile; the market price may end the day above or below the offering price
Exam Tip: Gotchas
The offering price is set by the underwriter and issuer before trading begins. Once the stock starts trading, the market price is determined by supply and demand and may diverge significantly from the offering price.