IPO (Initial Public Offering) is the first public sale of a company’s shares (including depositary receipts). It is the first public offering to investors, inviting them to become shareholders. In Russia, the term is also used to refer to the secondary placement of shares on the market, but this does not change the meaning. When referring to an IPO, it means the opportunity to purchase shares on the primary market (the secondary market is the stock exchange).
IPO: Investor Risk
The goal of conducting an IPO is for the company to raise additional funds for its development. In addition, by selling their shares, company owners diversify their assets.
For investors, participation in an IPO carries significant risks, as errors can occur in the evaluation of a company that has not previously traded on the stock exchange, whether underestimating or overestimating its value. This is especially common with companies in the high-tech sector, where investors lack sufficient data to make an objective assessment of the company’s profitability.
Technical Aspects of IPO
The public offering of shares during an IPO involves selling shares to an unlimited number of people. This is the main difference between an IPO and a private placement, where shares are sold to a limited number of institutional investors.
The initial offering refers to a situation where the company’s shares have not previously traded on the stock exchange. Otherwise, it is called a secondary public offering.
During an IPO, the company acts as the seller of the shares. The funds raised from the offering can be used for various purposes: company development, repayment of debt obligations, and more. In some cases, current shareholders may sell their shares during the IPO, in which case the proceeds go directly to the selling shareholders rather than the company.
The initial offering of shares is a complex and time-consuming process involving marketing, investment, and legal services.
Preparation for IPO Includes:
- Optimization of corporate governance, including simplifying the corporate structure, developing a dividend policy, and adding independent members to the board of directors;
- Conducting an audit according to international financial standards;
- Preparing an investment memorandum;
- Conducting a promotional campaign among participants in the investment market (road show).
After deciding to conduct an IPO, the company announces a competition among investment banks to select the advisor for the IPO – underwriters. Underwriters evaluate the company’s prospects and, based on fundamental analysis, calculate the price range within which the company’s shares can be offered. If the owner is satisfied with the calculated range, the next step is for investment consultants to present the company to professional institutional and retail investors.
The next stage is building the order book of investor applications for share purchases. Then, the final IPO price and the number of shares each applicant receives are determined. After these procedures, the shares are transferred to new owners and listed on the stock exchange. In some cases, underwriters have the right to purchase shares, and sometimes they have an obligation to buy the shares that were not sold during the IPO.
Why Do Company Owners Need an IPO?
Typically, a 10-20% stake in the company’s shares is offered in a public offering. This is done to ensure the owner retains control over the company. A company owner may conduct an IPO for several reasons.
The first reason: insufficient financial resources. That is, the company lacks the funds needed for growth (such as purchasing new equipment, modernizing existing facilities, launching new products, etc.). In addition, having a public valuation allows the company to use its shares as collateral for loans or in merger and acquisition deals. In other words, through the IPO, the company reduces the cost of raising capital in the future.
The second reason: reducing risk. If the owner believes it is too risky to keep all funds in one company, they may sell part of their shareholding, reinvest the proceeds into alternative projects, thus rebalancing their investment portfolio.
Can You Make Money from an IPO?
According to financial theory, on average, the price of shares tends to be undervalued during an IPO. In some cases, the undervaluation can reach tens of percentage points. For example, after the IPO of Yandex, its shares rose by more than 50% on the first day of trading.
Sometimes, the rapid increase in share prices in the first few days after an IPO is explained by excessive emotional reactions without rational basis. However, this does not always happen, and investors often lose money in public share offerings. An example is the case of Global Depositary Receipts of Tinkoff Credit Systems (TCS Group Holding). After the October IPO, the company’s shares were priced at $17.5. Within a month, on November 15, the shares dropped by 42.3% to $9. The underwriters were well-known banks such as JP Morgan and Goldman Sachs.
Naturally, company owners are interested in maximizing the value of their shares. Before an IPO, there is always an active marketing campaign to generate interest in the company’s shares. Sometimes, due to an overly high price set by the owner, demand turns out to be so low that the IPO is postponed.
In some cases, the initial offering may proceed, but the share price may be so inflated that it drops significantly shortly after the IPO.
In summary, the initial public offering represents a relatively risky investment strategy that can lead to either significant profit or substantial losses.
Other articles in the masterclass:
- Inflation and Deflation: Two Sides of the Same Coin
- Quantitative Easing – QE
- Interest Rates: Risk-Free Income
- The Frightening Word ‘Default’
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“excerpt”: “An IPO can offer both profit and loss opportunities for investors. Understanding the risks and benefits of participating in an IPO is crucial for making informed decisions.”,
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FAQ
What is an IPO?
An IPO stands for Initial Public Offering, which is when a private company offers its shares to the public for the first time.
Why do companies conduct IPOs?
Companies conduct IPOs to raise capital for growth, diversify ownership, and increase visibility in the market.
Are IPOs risky for investors?
Yes, IPOs carry significant risks because the valuation of a company not previously traded on the stock exchange can be inaccurate, leading to potential losses.
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