A Basic Understanding of Initial Public offerings

A Basic Understanding of Initial Public Offerings

August 10, 2005

Investments FIN 3105

Table of Contents

Creation of IPOs ............................................................................................. 2

Contract ............................................................................................... 2

Structured Agreements .............................................................................. 2

Underwriters ......................................................................................... 2

Securities and Exchange Commission (SEC) ............................................................ 2

Registration Statement .............................................................................. 2

Investigation .......................................................................................... 3

Prospectus ..................................................................................................... 3

Red Herring .......................................................................................... 3

Road Show ........................................................................................... 3

Price ................................................................................................... 3

IPO Allocation ................................................................................................ 3

Institutional Investors .............................................................................. 3

Individual Investors ................................................................................. 4

Researching an IPO ........................................................................................... 4

Key Elements ......................................................................................... 4

Lockup Period ........................................................................................ 4

Flipping ................................................................................................ 4

Overall IPO Basics ............................................................................................ 5

Form .................................................................................................... 5

Categories ............................................................................................. 5

Reasons to go Public ......................................................................................... 5

Internet Boom .................................................................................................. 6

References ...................................................................................................... 7

A Basic Understanding of Initial Public Offerings

Initial Public Offerings (IPOs) are common ways for small companies to grow and expand by increasing their availability of capital. The Initial Public Offering started seeing a strong increase in popularity in the late 1990's. As a result of the growing popularity resulting in the dot com explosion, the term "IPO" became a household name. In order to understand how IPOs work, its best to first know how IPOs are created.

IPOs are created by underwriters. The first step in creating the IPO is to hire an investment bank and negotiate a contract. The contract will state the type of securities (either stocks or bonds), the amount of capital to be raised, and the details of the actual underwriting agreement. The company and the investment bank determine the structure of the contract. There are two different types of structured agreements. The first type of structured agreement is the firm commitment agreement, in which the underwriter guarantees that a certain amount of capital will be raised. This is done through buying the entire offer and reselling it to the public. The second type of structured agreement is the best effort agreement, in which the underwriter will sell the securities for the company but does not guarantee how much capital will be raised. To protect themselves with IPOs, an investment bank will often form a syndicate of underwriters. When a syndicate is formed, a lead underwriter will be in charge of the syndicate, while the others will each sell a portion of the securities issued. Once a contract agreement is reached, the investment bank files a registration statement with the Securities and Exchange Commission (SEC) (IPO, 2005).

The registration statement contains information about the offering itself along with other information about the company, such as the company's financial statements, management background, any legal issues the company may be involved in, insider holdings, and where the raised capital will be used within the company. After the registration statement is filed with the SEC, there is a required "cooling off" period. During this period, the SEC investigates whether or not there has been a full disclosure of information. Once the SEC finishes its investigation, they will usually approve the offering and set an effective date for the stock to be offered to the public. During the "cooling off" period, while the SEC is performing its investigation, the underwriters put together the initial prospectus, also known as a "red herring." This prospectus contains all of the information about the company but excludes the offer price and effective date, which are both unknown at the time the prospectus is written. The red herring will allow the underwriter and the company to build interest in the issue with institutional investors during a promotional "road show." It is also during the "road show" period