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Intro to IPOs

What are IPOs?

An "initial public offering" is a company's first sale of stock to the public. This is why it is also referred to as "going public". When a company that has already issued stock issues more stock it is called a "secondary offering".

Why do companies do IPOs?

  • Raise cash for growth - The biggest reason companies do IPOs is to raise capital to meet the capital needs of the business. If a small company is doing $100 million in sales and it believes it could get up to $2 billion then it might take a while if its growth is funded from internal profits. So it sells part of the company to investors (the public) and uses the money to grow quicker than it would have otherwise.

  • Raise cash for other reasons - For example, having cash makes it easier to acquire other companies. Buying other companies requires a lot of cash. Doing an IPO allows companies to raise cash as well as utilize their publicly traded stock as a currency to purchase other companies (called a "stock swap").

  • Cachet - Being a public company can also give you cachet because people tend to trust a company more if it is public. A small company looking to create a strong brand with their customers may be able to use their status as a publicly traded company as a marketing tool - although this reason by itself is rarely enough for a company to do an IPO.

  • Create liquidity for their stock options program - If a company is a private company and they give out stock options to employees then there is no public market for them to trade on. Having a publicly traded stock makes it easier for option holders to realize the value of their options. When Microsoft did their IPO in 1986, they weren't hampered by venture capitalists looking to cash in their profits. Nor did they need the cash with profit margins in the 30% range. But Gates had granted so many stock options (and stock) to managers and programmers in order to attract the best talent, yet there was no public market for the option and stock owners to trade their shares.

  • Regulations The SEC has a rule that once a company reaches 500 shareholders (including stock options), they must register their financial information with the SEC. Although an IPO is not necessarily required, the additional costs and hassle of doing an IPO are not minimal, considering that they the company is already paying a lot of money to meet its regulatory reporting requirements. Google was forced to file for an IPO in 2004 after they hit the 500 mark. Facebook, in May 2012, passed 500 shareholders and did an IPO.

  • Exit strategy - See below.

The truth about (some) IPOs

I talked earlier about how the reason that a company issues stock was to raise money to meet the long-term capital needs of the business and many times to fund the company's growth. Well, this was based on the assumption that the owners of the company believe that the best times for the company are in the future so the company needs to raise money if it wants to take advantage of these opportunities.

But one of the things that is rarely mentioned is that sometimes a company is taken public because the owners believe the best times for a company (from a valuation standpoint) are behind it. In this case the IPO serves as an "exit strategy", or a way to sell the company so the owners can cash in their profits (also referred to as a "liquidation event").

Some investors may think this is unfair. But as long as there is enough information for investors to make an accurate assessment of the company's value then it isn't. If investors want to pay too much for a stock based on that information then they have a right to do that. Most investors operate under the illusion that all IPOs are growth companies with great prospects. People forget sometimes that the IPO process is simply a process where a seller sells a stock to a buyer. An owner of a stock usually sells the stock because they think the value has been realized. This happens with IPOs too.

How is an IPO done?

The process by which an IPO is issued is called an "underwriting". When a company wants to go public they contact an investment bank (usually one of the big ones on Wall Street) and hammer out the terms of the deal (like how much money to raise, how many shares to issue, etc.). The investment bank agrees to sell the shares to the public. Sometimes the investment bank will agree to buy the shares directly from the company and re-sell them to the public. Many times a single investment bank will not want to shoulder the whole risk of an IPO so they will team up with other investment banks to form what is called a "syndicate" where one bank is the lead underwriter. Any investment bank involved in the IPO will earn a commission based on a percent of the money raised in the IPO.

There have been attempts over the past few years to revolutionize the IPO process by eliminating the investment banks from the IPO process. None of these efforts have gained any substantial traction. Personally, I think the IPO market is ripe for innovation because one of the big trends over the last few years in business has been to mitigate the role of the middleman. And the investment banks who act as middlemen in the IPO process earn enormous fees for doing so. Although some people may point out the risk involved and how complicated the process is, I believe there is considerably less risk than say deriving your income from correctly calling market trends. The big Wall Street investment banks seem to get the all the business only because they are large and prestigious. But I believe some of the medium-sized financial firms who don't have much market share in IPOs would do well to underprice the big Wall Street firms. The process of doing an IPO, after all, has been around for a long time and does not require unique technology.

The IPO market

If you read the business news regularly you will see people referring to the "IPO market". They are referring to how many companies have gone public recently and how many are scheduled to go public soon. Even investors who don't buy IPOs usually keep an eye on the IPO market. This is because the IPO market is an indicator of the public's hunger for stocks in general.

Because IPO activity is somewhat of a gauge of supply and demand for equities, the IPO market is commonly used as a contrary indicator. In other words, when tons of companies are doing IPOs then it means people are euphoric about the market and it is probably time to sell. The dotcom era of the late 90's was one of the best examples in history of using the IPO as a market indicator. If you want to get technical, you could graph the number of monthly IPOs and overlay it onto a stock index chart. If you want to monitor the IPO market here are a few indicators you can use:
  • The number of IPOs this quarter vs. the same quarter last year.

  • The number of IPOs last quarter vs. this quarter.

  • The return of the IPOs on their first day of trading.

  • The return of all IPOs year-to-date.

  • The quality of the companies going public.

  • How many IPOs get delayed because of lack of demand.

  • The total market cap of all IPOs this year vs. last year.

Amateur investors & IPOs

This first thing beginners need to learn about IPOs is that IPOs are nothing special. One of the biggest areas where amateur investors show their flaws when it comes to investing is with IPOs. Amateur investors are often seduced by IPOs because they believe that the companies going public are somehow better investment opportunities. They're not. They are just regular companies just like all other companies. There will be opportunities where there IPOs that are way underpriced but those opportunities are no different than opportunities in stocks that have been trading for a while.


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Options Valuation
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