Steps in an initial public offering

Assuming that the benefits outweigh the costs, there are five steps involved in an initial public offering.

Step 1: Choose an investment banker based upon reputation and marketing skills. In most initial public offerings, this investment banker underwrites the issue and guarantees a specified price for the stock. This investment banker then puts together a group of several banks (called a syndicate) to spread the risk of the offering and to increase marketing reach. Step 2: Assess the value of the company and set issue details: This valuation is generally done by the lead investment bank, with substantial information provided by the issuing firm.

8 Black and Gilson (1998) argue that one of the reasons why venture capital is much more active in the U.S. than in Japan or Germany is because the option to go public is much more easily exercised in the U.S.

9 The costs are two fold. One is the cost of producing and publicising the information itself. The other is the loss of control over how much and when to reveal information about the firm to others.

10 This may sound like an odd term, but it is accurate. Buy recommendations from equity research analysts following the firm provoke investor interest and can have a significant impact on the stock price; sell recommendations, on the other, can cause the stock price to drop. This is especially true for small, unknown firms.

The value is sometimes estimated using discounted cash flow models. More often, though, the value is estimated by using a multiple, like a price earnings ratio, and by looking at the pricing of comparable firms that are already publicly traded. Whichever approach is used, the absence of substantial historical information, in conjunction with the fact that these are small companies with high growth prospects, makes the estimation of value an uncertain one at best. Once the value for the company has been estimated, the value per share is obtained by dividing by the number of shares, which is determined by the price range the issuer would like to have on the issue. If the equity in the firm is valued at $ 50 million, for example, the number of shares would be set at 5 million to get a target price range of $10, or at 1 million shares to get a target price range of $ 50 per share. The final step in this process is to set the offering price per share. Most investment banks set the offering price below the estimated value per share for two reasons. First, it reduces the bank's risk exposure. If the offering price is set too high and the investment bank is unable to sell all of the shares being offered, it has to use its own funds to buy the shares at the offering price. Second, investors and investment banks view it as a good sign if the stock increases in price in the immediate aftermath of the issue. For the clients of the investment banker who get the shares at the offering price, there is an immediate payoff; for the issuing company, the ground has been prepared for future issues.

Step 3: Gauge investor demand at the offering price: In setting the offering price, investment bankers have the advantage of first checking investor demand. This process, which is called building the book, involves polling institutional investors prior to pricing an offering, to gauge the extent of the demand for an issue. It is also at this stage in the process that the investment banker and issuing firm will present information to prospective investors in a series of presentations called road shows. In this process, if the demand seems very strong, the offering price will be increased; in contrast, if the demand seems weak, the offering price will be lowered. In some cases, a firm will withdraw11 an initial public offering at this stage, if investors are not enthusiastic about it.

Step 4: Meet SEC filing requirements and issue a prospectus: In order to make a public offering the United States, firms have to meet several requirements. First, they have to file a registration statement and prospectus with the SEC, providing information about the firm's financial history, its forecasts for the future and how it plans for the funds it raises from the initial public offering. The prospectus provides information about the riskiness and prospects of the firm for prospective investors in its stock. The SEC reviews this

11 One study of initial public offerings between 1979 and 1982 found that 29% of firms terminated their initial public offerings at this stage in the process.

information and either approves the registration or sends out a deficiency memorandum asking for more information. While the registration is being reviewed, the firm may not sell any securities, though it can issue a preliminary prospectus, titled a red herring, for informational purposes only. Once the registration has been approved by the SEC, the firm can place a tombstone advertisement in newspapers and other publications. Step 5: Allocate stock to those who apply to buy it at offering price: If the demand for the stock exceeds the supply (which will happen if the offering price is set too low), you will have to ration the stock. If the supply exceeds the demand, the investment banker will have to fulfill the underwriting guarantee and buy the remaining stock at the offering price.

On the offering date — the first date the shares can be traded — the market price is determined by demand and supply. If the offering price has been set too high, as is sometimes the case, the investment bankers will have to discount the offering to sell it and make up the difference to the issuer, because of the underwriting agreement. If the offering price is set too low, as is often the case, the traded price on the offering date will be much higher than the market price, thus enriching those who were allocated shares in the initial public offering.

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