What is Initial Public Offering (IPO)?

UTC by Osaemezu Ogwu · 9 min read
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What is Initial Public Offering (IPO)?

Here you’ll find what initial public offering (IPO) is, how it works, learn the advantages and disadvantages of this funding model.

In general, initial public offering (IPO) involves conducting the sales of shares in a private company. IPO comes with premium shares for the company’s investors, and also offers public investors an opportunity to own a part of the company shares.

Read this guide to find out how IPO works, learn what are the advantages and disadvantages of this funding model and where’s the balance between keeping control of the company and attracting more investors.

How Does Initial Public Offering Work?

Here’s an outline on the operation of IPOs:

Companies that haven’t launched an IPO are called private companies. The latter has advanced thanks to its shareholders and early investors such as family members, close friends, angel investors, etc.

The business grows and when it gets to a stage that it knows it’s able to meet the SEC‘s strict regulation for a public company, it launches an initial public offering. The company proceeds to reveal its plan to launch an IPO. Nonetheless, a company is ready for an IPO if its valuation is around $1 billion. Reaching this valuation earns the company a unicorn status.

It’s also possible for companies whose valuation isn’t up to a $1 billion to qualify to launch an IPO. They may have great potential to yield profit and even have major fundamentals. Besides, they may pose tough competition in the industry they are and even meet the requirements for listing.

Further, a company that has gone public is required to offer disclosure statements on a regular basis. It will also make its financial information publicly known. There’s also the expectation for these companies to answer to their shareholders. As such, management tends to lose a certain amount of control in their own company in exchange for funding.

Benefits of IPO for Companies

Companies that embark on an IPO benefit from the funds raised from investors. Therefore, this event is a milestone for any corporation. Having the capital it needs to design its product or service can promote its growth and within a shorter time frame.

Another notable benefit of an initial public offering is enabling the company to borrow funds with better terms. Here, the transparency of its share’s listing can put it in the best light.

IPO Shares Pricing

A company’s IPO shares pricing is done using underwriting due diligence. Further, the shares held by the current shareholders are valued using their public trading price.

However, there are special provisions when it comes to share underwriting. This underwriting pertains to private and public share ownership.

In this case, the move from a private to a public company enables private investors to get returns for their investment. These investors may choose to liquidate some or all of their shares. They also have the option of holding back to these shares.

Initial Public Offering Investors

The public can make investments in companies that have gone public. The investors can be wealthy individuals or retail investors. The IPO gives them a chance to buy the company’s shares, which could be priced higher at a later time. As such, it results in a profit for the buyer.

Also worthy of note is the number of shares and the price at which these shares are sold determines the equity value for the company’s new shareholders. This equity signifies the investor’s shares whether the company is private or public. An IPO also helps the equity of the shareholder to increase significantly while there’s also cash from primary issuance.

Advantages of an Initial Public Offering

Asides from enabling businesses to generate funds, IPOs also offer the following advantages:

  • IPOs make provision for a corporation to create more funds at a later time using other offerings since an IPO gave them entry into the market.
  • Public companies have more potential to attract skilled workers and even better managers.
  • Public companies can gain from a lesser capital cost in relation to debt and equity.
  • IPOs help to improve the company’s visibility. It helps its reputation to grow which could also impact its profits.

Keeping Control of Your Business After the IPO

It’s important to have more control over your company as the owner or founder even after an IPO. There may have been shareholders, investment companies, etc. promoting its growth, but it’s shouldn’t be left solely to these entities to determine how your business operates. The latter will ensure that your sweat, resources, and dedication is not washed down the drain. Accordingly, there are ways to exercise control over your company after its IPO. Some of these are:

Setup Stock Classes

Quite common for publicly owned companies to offer various stock classes. These classes determine the shareholder’s voting rights. Accordingly, there are Class A and B shares, and the former often offer more rights to shareholders. Here, Class A investors could have a hundred votes per share. Alternatively, a Class B investor may have a vote per share. The reverse is the case. Hence, Class B shares can be given higher rights compared to Class A. These shares with higher rights are often referred to as super-voting shares.

Accordingly, founders and generally stockholders can be given super-voting shares. The latter will give them a certain degree of power in the corporation. Consequently, it becomes difficult for a takeover to be possible with rights focused on a certain class of stockholders. This setup means that the business has the option of publicly offering shares whose voting rights are lesser.

Class B Shares Investors may be uncertain if the company founders’ will act to bring good to the public. And their actions could lead to the poor performance of the company’s stock. When this uncertainty arises, then Class B investors could make attempts to bring about a vote that will eliminate the classes of shares. The goal is to remove disparity in voting rights.

Become a Controlled Company

A controlled company is one that an individual or group own 50% of its shares. Also, there is no requirement for the business to employ non-dependent leaders to oversee its operation. The point is, individuals involved in the audit, and other aspects are expected to be non-dependent.

Another way to go about it is to become a company controlled by family members. The latter ensures founders as with their family members have greater shares in the company. They also get to choose the leaders. Besides, the setup of this nature is quite popular given that almost several companies Fortune Global 500 adopt this strategy. There’s WalMart, for instance, and it is operated by the children of Sam Walton, the platform’s founder.

Disclose Control

It’s important to disclose the company’s control to shareholders. This disclosure is made in reports that are publicly filed. As such, it gives shareholders a good idea about what they’re investing in. Much more, they’re informed of the risks associated with investing in a controlled company. For starters, these companies sometimes underperform when compared to non-controlled firms. Coupled with that, controlled companies are believed to be less accountable.

Adopt Alibaba’s Strategy

Alibaba, an eCommerce company adopted a unique strategy when it launched its IPO in 2014. Rather than resorting to classes to enable owners to have control of the company, it resorted to using 27 partners. Accordingly, these partners were tasked with the duty of overseeing the board and reduce the input of outside shareholders.

Alibaba’s 27 member team has grown to 30. And this team will grow larger as fresh partners are selected or existing ones leave. However, partners are not required to liquidate their holdings, and shareholders from the public are unable to choose directors that will make certain decisions in the company.

Furthermore, there are Alibaba’s articles of association which places a limit on how much control a third party can have in the company. There are staggered terms targeted at board members and these terms ensure that these individuals are not replaced simultaneously.

It may also interest you to know that Alibaba had one of the largest IPOs even though its stock price has now decreased. It was the largest IPO, and it ranked top in the face of potential conflicts among the company’s shareholders.

Ensure a Wide Distribution of Shares

Another alternative is allowing board members to have less than fifty percent of shares. These members can still have control while outside investors do not have a higher proportion of shares. Therefore, it’s not crafted on a stone that you must use various classes whose rights differ.

This setup as ad advantage since it could be better suited for outside shareholders. These may be individuals who are out to get voting rights equivalent to that of insiders. On the other hand, there’s the disadvantage of not being able to control who gets the share since outsiders can sell to whoever they want. The latter could enable a takeover.

Are IPOs Good Investments?

IPOs have immense benefits to the company launching them, however, they may not always be beneficial to investors. It may be profitable for some investors or result in losses for others. These losses may be more evident in inexperienced investors. The level of risk is also higher when investments are made in companies that do not have a good historical performance,

Furthermore, there is the potential for initial public offerings to underperform and the poor performance could span across years. This performance may occur after the issuance of stocks to the public. The reason can be tied to some company’s focus on the business’ growth rather than generating profits for investors. That being said, it is important for anyone investing in IPOs to assess the company they’ll be investing in thoroughly.

History’s Largest Initial Public Offerings

Alibaba Group: Received funds worth $25 billion in 2014

Softbank Group: Received funds worth $23.5 billion in 2018

American Insurance Group: Received funds worth $20.5 billion in 2006

VISA: Received funds worth $19.7 billion in 2008

General Motors: Received funds worth $18.15 billion in 2010

Facebook: Received funds worth $16.01 billion in 2012

Conclusion

An initial public offering is beneficial to both companies and investors. It offers companies an opportunity to raise funds that could potentially spur its growth. On the other hand, investors can earn from investing in these companies. In the end, its a win-win for both parties. Therefore, you can resort to this piece of information if you’re a company about to go public or an investor looking for a potential company.

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