Initial Public Offerings
An initial public offering (IPO) is the process by which a private company transforms itself into a public company. The company offers, for the first time, shares of its equity (ownership) to the investing public. These shares subsequently trade on a public stock exchange like the New York Stock Exchange (NYSE) or the Nasdaq.
The first question you may ask is why a company would want to "go public." Many private companies succeed remarkably well as privately owned enterprises - even a company as large and well-known as UPS (the United Parcel Service) is a private firm. Another privately held company, Cargill, tops $50 billion in revenue each year. And until recently, Wall Street's leading investment bank, Goldman Sachs, was a private company. However, for many private companies, a day of reckoning comes for the owners when they decide to sell a portion of their ownership in their firm.
The primary reason for going through the rigors of an IPO is to raise cash to fund the growth of a company. For example, industry observers believe that Goldman Sachs' partners wished to at least have available a publicly traded currency (the stock in the company) with which to acquire other financial services firms.
While obtaining growth capital is the main reason for going public, it is not the only reason. Often, the owners of a company may simply wish to "cash out" either partially or entirely by selling their ownership in the firm in the offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm. Or, sometimes a company's CEO may own a majority or all of the equity, and will offer a few shares in an IPO, in order to "diversify his/her net worth" or to "gain some liquidity." To return to the example of Goldman Sachs, some felt that another driving force behind the partners' decision to go public was the feeling that financial markets were at their peak, and that they could get a "good price" for their equity in their firm.
It should be noted that going public is not a slam dunk. Only companies with solid track records and abundant growth opportunities make good IPO candidates. Firms that are too small, too stagnant or too unprofitable will - in general - fail to find an investment bank willing to underwrite their IPOs.
From an investment banking perspective, the IPO process consists of these three major phases: hiring the mangers, due diligence, and marketing.
Hiring the Managers: The first step for a company wishing to go public is to hire managers for its Bering. This choosing of an investment bank is often referred to as a "beauty contest." Typically, this process involves meeting with and interviewing investment bankers from different firms, discussing the firm's reasons for going public, and ultimately nailing down a "valuation." In making a valuation, I-bankers, through a mix of art and science, pitch to the company wishing to go public what they believe the firm is worth, and therefore how much stock it can realistically sell. Perhaps understandably, companies often choose the bank that provides the highest valuation during this "beauty contest" phase instead of the best-qualified manager. Almost all IPO candidates select two or more investment banks to manage the IPO process.
Due Diligence and Drafting: Once managers are selected, the second phase of the process begins. For investment bankers on the deal, this phase involves understanding the company's business as well as possible scenarios (called due diligence), and then filing the legal documents as required by the Securities Exchange Commission (SEC). The SEC legal form used by a company issuing new public securities is called the S-l (or prospectus) and requires quite a bit of effort to draft. Lawyers, accountants, I-bankers, and of course company management must all toil for countless hours to complete the S-l in a timely manner.
Marketing: The third phase of an IPO is the marketing phase. Once the SEC has approved the prospectus, the company embarks on a "roadshow" to sell the deal. A roadshow involves flying the company's management coast to coast (and often to Europe) to visit institutional investors potentially interested in buying shares in the offering. Typical roadshows last from two to three weeks, and involve meeting literally hundreds of investors, who listen to the company's canned presentation, and then ask scrutinizing questions. Often, money managers decide whether or not to invest thousands of dollars in a company within just a few minutes of a presentation.
The marketing phase ends abruptly with the placement of the stock, which results in a new security trading in the market. Successful IPOs "trade up" on their first day (increase in share price), and tend to succeed over the course of the next few quarters. Young public companies that miss their numbers are dealt with harshly by institutional investors, who not only sell the stock, causing it to drop precipitously, but also blame management and lose faith in the management team.
Follow-on offering of stock
A company that is already publicly traded will sometimes sell stock to the public again. This type of offering is called a follow-on offering, or a secondary offering. One reason for a follow-on offering is the same as a major reason for the initial offering: a company may be growing rapidly, either by making acquisitions or by internal growth, and may simply require additional capital.
Another reason that a company would issue a follow-on offering is similar to the "cashing out" scenario in the IPO. In a secondary offering, a large existing shareholder (usually the largest shareholder, say, the CEO) may wish to sell a large block of stock in one fell swoop. The reason for this is that this must be done through an additional offering (rather than through a simple sale on the stock market through a broker), is that a company may have shareholders with "unregistered" stock who wish to sell large blocks of their shares. By SEC decree, all stock must first be registered by filing an S-l (or S-2) document before it can trade on stock exchange. Thus, pre-IPO shareholders who do not sell shares in the initial offering hold what is called "unregistered" stock, and are restricted from selling large blocks unless the company files an S-2 form.
There are two types of shares that are sold in secondary offerings. When a company requires additional growth capital, it sells "new" shares to the public. When an existing shareholder wishes to sell a huge block of stock, "old" shares are sold to the public. Follow-on offerings often include both types of shares.
Let's look at an example. Suppose Acme Company wished to raise $100 million to fund certain growth prospects. Suppose that at the same time, its biggest shareholder, a venture capital firm, was looking to "cash out," or sell its stock.
Assume the firm already had 100 million shares of stock trading in the market. Let's also say that Acme's stock price traded most recently at $20 per share. The current market value of the firm's equity is:
Say XYZ Venture Capitalists owned 10 million shares (comprising 10 percent of the firm's equity pre-deal). They want to sell all of their equity in the firm, or the entire 10 million shares. And to raise $100 million of new capital, Acme would have to sell 10 million additional (or new) shares of stock to the public. These shares would be newly created during the offering process. In fact, the prospectus for the follow-on, called an S-2 (as opposed to the S-l for the IPO), legally "registers" the stock with the SEC, authorizing the sale of stock to investors.
The total size of the deal would thus be 20 million shares, 10 million of which are "new" and 10 million of which are coming from the selling shareholders, the VC firm. Interestingly, because of the additional shares and what is called "dilution of earnings" or "dilution of EPS," stock prices typically trade down upon a follow-on offering announcement. (Of course, this only happens if the stock to be issued in the deal is "new" stock.)
After this secondary offering is completed, Acme would have 110 million shares outstanding, and its market value will be $1.1 billion if the stock remains at $20 per share. And, the shares sold by XYZ Venture Capitalists will now be in the hands of new investors in the form of freely tradable securities.
Market Reaction: What happens when a company announces a secondary offering indicates the market's tolerance for additional equity. Because more shares of stock "dilute" the old shareholders, the stock price usually drops on the announcement of a follow-on offering. Dilution occurs because earnings per share (EPS) in the future will decline, simply based on the fact that more shares will exit post-deal. And since EPS drives stock prices, the share price generally drops.
The Process: The follow-on offering process changes little from that of an IPO, and actually is far less complicated. Since underwriters have already represented the company in an IPO, a company often chooses the same managers, thus making the "hiring the manager" or "beauty contest" phase much simpler. Also, no valuation is required (the market now values the firm's stock), a prospectus has already been written, and a roadshow presentation already prepared.
Bond offerings
When a company requires capital, it sometimes chooses to issue public debt instead of equity. Almost always, however, a firm undergoing a public bond deal will already have stock trading in the market. (i.e., it is very rare for a private company to issue bonds before its IPO.)
The reasons for issuing bonds rather than stock are various. Perhaps the stock price of the issuer is down, and thus a bond issue is a better alternative. Or perhaps the firm does not wish to dilute its existing shareholders by issuing more equity. These are both valid reasons for issuing bonds rather than equity. Sometimes in down markets, investor appetite for public offerings dwindles to the point where an equity deal just could not "get done" (investors would not buy the issue).
The bond offering process resembles the IPO process. The primary difference lies in: 1. the focus of the prospectus (a prospectus for a bond offering will emphasize the company's stability and steady cash flow, whereas a stock prospectus will usually play up the company's growth and expansion opportunities) and 2. the importance of the bond's credit rating (the company will want to obtain a favorable credit rating from a debt rating agency like S&P or Moody's, with the help of the "credit department" of the investment bank issuing l bond; the bank's credit department will negotiate with the rating agencies to obtain the best possible rating). The better the credit rating - and therefore, the safer the bonds, the lower the interest rate the company must pay on the bonds to entice investors debt rating on the issue. Clearly, a firm issuing debt will want to have the highest possible bond rating, and hence pay a low interest rate (or yield).
