how do IPOs work?

WTF: How Do IPOs Work?

Few things create as much excitement in the business world as Initial Public Offerings (IPOs), when shares of hot companies are sold to the public, often for huge amounts. But as billions change hands, some have questioned where the money goes.

how do IPOs work?

Each year, there’s an average of about 100 IPOs in the United States, according to a paper hosted by the Securities and Exchanges Commission (SEC).

There were twice as many in 2013, however: 222 companies raised a total of $54.9 billion, according to Fox Business, making it the best year for IPOs since the dot-com bubble burst in 2000.

According to the Motley Fool, a financial blog, 29 of these companies doubled their value following the IPO, with six of them doubling in value on the very first day of trading.

How it works

Clearly, IPOs can be valuable for both the company involved and investors. This is how they work:

A privately held company, owned by individual people (usually founders and early investors), decide to raise money by selling shares of the company to the public.

They file a prospectus, a detailed document that describes the state of the company, including financial statements about the company, a list of risk factors, and a description of the company’s business model, among other things, according to a guide to IPOs by the SEC.

The company then works with an investment bank which acts as an underwriter, which means that they value the company, set the share price, and take on the risk of distributing the company stocks.

This underwriter, which receives a percentage of money raised through a fee, works with groups of investors, who are then invited to buy shares of the company at the initial offering price.

If they choose to participate in the IPO this way, they can either hold on to the shares if they anticipate an increase in the company’s value, or sell it along with the underwriter.

When the IPO occurs, often with much fanfare, shares are then sold to the general investing public on a stock exchange such as the NASDAQ or the New York Stock Exchange.

Why do an IPO?

For the company offering shares, it provides cheap capital from a diverse base of investors, makes acquisitions of other companies easier through share offerings, and offers a publicity boost.

There are also some disadvantages, however, such as the monetary cost (anywhere from $250,000 to $1 million, according to attorney office Lewis & Kappes), potential information revealed to competitors through the prospectus, and pressure from stockholders to increase earnings.

Criticism

IPOs can be a very exclusive exercise, as an elite group of investors associated with the underwriters are privy to information about the company before the public.

A famous example of this is the Facebook IPO, labeled by most experts as an unmitigated disaster.

After a last-minute, downwards correction of Facebook’s potential revenue, investors in the know were able to place bets against the company’s stocks. Knowing that the stock was overpriced, they shorted in massive quantities, leaving regular retail investors losing as much as $630 million, according to Bloomberg.

The reverse of this situation is also common, however: underwriters frequently undervalue the initial price of the stock, according to Joe Nocera at the New York Times, allowing their clients to buy undervalued stock before the IPO, then cashing in as the price rises.

Firms then make massive quantities – far above the underwriter commission fee – by demanding kickbacks from clients.

The most famous example of this is Goldman Sachs’ alleged undervaluing of eToys.com in 1999 – the lawsuit over which the bank finally settled in September 2013.

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Ole Skaar