Initial Public Offerings

The very first sale of stocks to the public is called an initial public offering (IPO),and occurs on the primary market.This tutorial will cover the following factors involved in initial public offerings:

The Process of Issuing Securities:

Corporations sell stock to the public as one way to raise capital. Before it can issue new stock, a corporation must first file registration statements with the Securities and Exchange Commission (SEC) A twenty-day wait is required before it can sell the stocks.

The issuing company may make their registration statement public with a preliminary prospectus called a red herring that summarizes the registration statement. Basic information about the new offering is also provided, including how many shares are being offered and which brokerage companies will distribute the stock to the public. At the time of issue, a final prospectus is presented. This includes the price of the stock (its offering price).

The Basics of Underwriting:

A Corporation going public hires an investment banker to help it sell its stock. This process is called underwriting. The investment banker functions as an intermediary between the issuing corporation and the public. In most cases, the underwriter (investment banker) purchases the stocks from the company for resale to the public. To reduce its own risk, the investment banker may form an underwriting syndicate of other investment bankers to co-purchase the shares. The underwriting syndicate forms a selling group to sell specified allotments of the issue. The investment banker (underwriting syndicate) then marks up the price of the offering. This markup represents the fee for the syndicate’s service. The difference between the price the underwriter pays and the price the public pays is called the underwriting spread.

The syndicate manager may bid on the stock in the offering to “stabilize” the price. This bid must be less than or equal to the offering price. By law, the prospectus must make this attempt to stabilize the stock price known to the public.

The SEC also requires the underwriter to investigate the issuing company-particularly any audits, how it uses proceeds, its financial statements and the management team. This process is called due diligence.

Types of Underwriting Arrangements:

A stock issue can be underwritten by several methods.

The underwriter can act as an agent, in which it tries to sell as much of the issue as it can at market prices. This is a best effort arrangement.

The issuing company can also agree to issue new stock on the condition that all of it is sold. If all of the stock is not sold, then it will withdraw the issue. This is an all-or-none arrangement.

A negotiated underwriting is when the issuer and the corporation negotiate the terms of the issue, the price, the size and other details.

The issue may be subject to competitive bids from investment bankers. The top bidder underwrites the issue and resells it to the public.

When a public company issues more of its stock, it must first offer that stock to existing shareholders; that is their preemptive right. A standby is the public sale of whatever stock the existing shareholders have not yet purchased.

A firm commitment arrangement is when an investment banker buys all of the stock from the corporation and then resells it to the public at a higher price.

A private placement is an offering in which the company sells to private investors and not to the public. Private placements do not have registration fees.

The Prospectus:

Prospectuses are legal documents that explain the financial facts important to an offering. They must precede or accompany the sale of a primary offering. The law requires companies selling primary offerings to send prospectuses to anyone who wants to buy a primary offering. Prospectuses may also be used to solicit orders. Customers should read a prospectus carefully before purchasing any primary offering.

Prospectuses include but are not limited to the following:

  • Offering price
  • Legal opinions about the issue
  • Underwriting method
  • The history of the company
  • Other costs related to investing in the stock
  • The management team
  • The handling of proceeds

The prospectus must be provided to customers before they complete any transactions. It must also include the SEC’s disclaimers that it does not approve or disapprove of the stock being offered, and that it does not judge the prospectus’ statements for accuracy.

Ways an Issue May Be Advertised Before it is Sold:

A new issue of stock is allowed to be advertised before it is actually sold, although it may not be sold during the actual registration period.

Registered representatives are allowed to accept oral solicitations from clients. They are not allowed to sell any shares of the new stock. Neither are they allowed to affirm any offers of sale.

Registered representatives may send red herrings, or preliminary prospectuses, to clients. Information in these documents will discuss why the stock is being sold and the offering timetable. Red herrings are only issued for information purposes.

Tombstone advertisements are ads that announce the new stock. Their sole purpose is to function as communication. They are not prospectuses. They are called tombstones because they provide prospective buyers with the “bare bones” information: the name of the stock, the issuer and how to obtain a red herring.

Newly Issued Stocks: Getting the Names Straight:

Two aspects of IPOs deserve special attention: hot issues and the so-called “when, as, and if- issued” stocks.

A hot issue is a security sold by broker-dealers on the secondary market just after it is first issued.

New stock may not be sold until after the registration period has expired. If the stock has not been issued by that time, it may be sold conditionally as a “When, as, and if-issued” stock. Should it fail to be issued, all buys, sells, earnings and losses will be canceled.

This concludes the introductory tutorial on initial public offerings. For more information on investing in IPOs check out the tutorial titled Investing in Initial Public Offerings.

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