Finance

The Pros and Cons of IPOs

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What is an IPO?

What is IPO, or an Initial Public Offering, is a common question among the beginner investors or people who are considering investment options in the stock market. Simply put, IPO takes place when the public is offered shares of stocks of a company for the first time.

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Generally underwritten by investment banks, in case of IPOs, the same investment banks also make the arrangements for the shares to be listed on various stock exchanges. Through the process, more commonly known as “going public” or “floating”, a private company, with a limited number of shareholders who mainly comprise of primary investors (founders, their friends and families) and professional investors (angel investors and venture capital providers), transforms into a publicly held company.

IPOs are generally utilized to increase additional equity capital for the company going public. As a result of IPOs, raising future capital and/or the trade of currently existing holdings becomes significantly more convenient. The monetization of investments made by the private shareholders, also including the private equity investors, is made simpler by using the Initial Public Offerings.

What are the primary and secondary markets?

There are two kinds of stock markets, the primary market and the secondary market. When a company issues its IPO, the shares of the company are eligible to be traded in the primary market. This means that the dealings will be made directly between the company and its new public investors. Once an IPO is released, investors can purchase shares of the company however, until the company is listed on the stock market, investors will not be able to sell their purchased shares.

Approximately seven days after the issue of an IPO, once the company has sold the shares they made public, the company in question becomes listen on the stock market. Once the company receives a listing, the investors are free to trade their shares on the market. A secondary market is the market where the trade of shares between buyers and sellers take place through a broker. Post the release of IPOs, all trade of shares takes place in the secondary market.

Why go public?

The primary reason why a company may go public is to raise a significant amount of cash as capital for their growth and expansion. There are a number of ways by which a privately held company can also raise money which include bringing in more private investors, borrowing the required amount from financial institutions, or even by letting another company acquire the company in question. However, the issue of IPOs is guaranteed to raise the largest sum possible for the company and its initial investors.

As a result of increased exposure and scrutiny, a publicly held company can get better rates when it issues debt. Other profitable reasons for a company going public includes the fact that the company can continue to issue stocks as long as there is a demand in the market, another reason being liquidity which comes as a result of open market trade. A publicly held company also has the ability to make implementations of plans such as the employee stock ownership plans which will make it a more lucrative option for talented employees.

What is the IPO Process of a company?

The very first step of the process is to form an IPO team which includes a representative from the investment bank hired by the company for the IPO process, lawyers, accountants, public relations professionals, SEC experts and investor relations specialists. The company and the investment bank sign an underwriting agreement that holds details regarding the financial operations of the IPO. Post that, the company and the bank file a registration statement with the SEC. The SEC analyzes the filed statement and the underwriting agreement and all other information made available. One the SEC signs off its approval, it sets a date for the launch of the IPO.

Pros of an IPO

  1. Issuing an IPO means a previously private company can diversify and expand its equity base which results in a larger and varied group of investors.
  2. An IPO makes it more inexpensive for a company to access capital or a reduced “cost of capital”.
  3. Liquid equity participation as a result of going public will allow the company to bring in and retain the very best employee and management team.
  4. A publicly held company can facilitate acquisitions, possibly in return for shares of stock.
  5. An IPO also raises the largest sum of money for the company to fund its expansion as compared to the alternatives solutions. It also creates a number of other monetary options such as cheaper bank loans, convertible debt, equity and more.
  6. The company will note a significant increase in its exposure, prestige, and public image, which in turn will greatly benefit its profits.

Cons of an IPO

  1. Before a company can make significant profits from the issue of an IPO, it has to spend a large amount on legal, accounting and marketing charges, many of which can stretch over a considerable period of time.
  2. As a result of the increased public exposure, the company is then required to disclose its business, tax, accounting and other previously private records to the public investors.
  3. Once the company goes public, it becomes important for management to provide meaningful time, attention and effort.
  4. If the IPO price is not accepted by the market, the risk that requires funding will not be raised. This brings in the possibility of the stock prices dropping immediately after the offering.
  5. As a result of the company going public, information that was private will also have to be made public. As a result, there is a risk of the information being misused by competitors, suppliers, and others. A public company also has to be the object of scrutiny from regulators that include the Securities and Exchange Commission.
  6. By bringing in public investors, the company has to relinquish its previously absolute control and the arrival of new shareholders may also result in agency problems.
  7. A publicly held company runs a higher risk of legal and/or regulatory issues.

Who can invest in an IPO?

An adult who is eligible to enter a legally binding contract can participate in the IPO process of a company. A Demat account and a PAN card are the other necessities, a trading account is not a compulsory requirement in case of IPOs.

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