Discussion Topic: IPO Definition, Pros, Cons
When you go through the newspaper, you often see an announcement by the company about of an IPO offering. If you are among those people who wonder what an IPO is or what is the meaning of IPO?. Then your search end here, we will guide you through the basics of IPO: What is an IPO? - definition, advantages, disadvantages, and entire concepts around it.
What is an IPO? - Definition
IPO is the acronym of Initial Public Offering. By definition, it is the process by which a privately held company offers its shares to the public for the first time to become a publicly traded company.
As by issuing the IPO, the company gets its name listed on the stock exchange. It's also termed as "going public”.
How Does a Company Offer IPO?
A company before it goes public hires an investment bank to handle the release of IPO. The investment bank and the company jointly calculate the financial details of the IPO in the underwriting agreement.
Later, along with the underwriting agreement, they file the registration statement with SEC (Securities and Exchange Commission). SEC scrutinizes the disclosed information and if found correct, it then allots a date to announce the IPO.
[For e.g.: In India, entire IPO process is regulated by the “Securities and Exchange Board of India (SEBI)”]
Why Does a Company Offer an IPO?
Assume that you are an entrepreneur, who started a company, along with a few partner members as the shareholders. The investment, profit, or loss of the Company is borne by these members. As the company continues to grow, it would require more capital to expand the business.
There one process you can get money is by taking a loan from banks, but it will costs you heavy interest. Another way is to offer company shares to the public and draw money from the market, which is interest-free. Also converting a company as a public company increases the brand value of it.
A company going public signifies that the brand has achieved enough success to get its name listed on the stock exchanges. In a demanding market, a public company can always issue more stocks and draw more public money as capital.
What Are The Advantages of IPO Offerings?
We will Now see the advantages or Pros of offering IPO. We will see the Pros from both the company's point of view and investors point of view.
Pros of IPO from the Company's View Point:
Raises a lot of money:
This is the primary reason for a company for going public. The company may need more money to pay off debts, to expand the business, to improve infrastructure and for many such reasons which they think will help in their future development.
Lower Cost of Capital:
Gives the company a way to gain capital at lower than the market rate. If the company borrows money from banks, they will charge interest on it. But if the company raises capital by issuing shares that there would be no obligation to provide any interest on that raised money.
Initially, the shareholders of the private company hold their shares in the form of equities. When the company goes public, it is the time when they can convert those equities to real money by selling it at market price.
Helps in Mergers and Acquisitions:
When a larger public company enters into a deal for an acquisition or a merger with smaller competitors, the terms of the deal typically include shares. This way cash flow to the smaller companies gets smoother and effective.
Increases Visibility and Credibility:
Going public increases the visibility and credibility of a company. In a public company, one can expect a better management and more transparency in fiscal data as they have to periodically report it to governing bodies.
Improves Financial Health:
Selling equities to the public would have generated a lot of capital and increases liquidity, which will be used for the better future of the company. Hence, the company will gradually approach towards a better financial situation, to apply for a loan or to negotiate the terms of the loans.
Pros of IPO from the Investor's View Point:
The IPO is also an exciting time for general investors. The initial shares are only available to those who know about it.
Many investors prefer to enter the market at the earliest phase. That's because IPO shares are often witnessed to gain huge value when they are first sold on the secondary market.
What are the Disadvantages of IPO Offering?
We will now see the disadvantages or Cons of offering IPO. We will see the Cons from both the company's point of view and investors point of view.
Cons of IPO from the Company's View Point:
High Upfront Cost:
Offering shares to the public is not at all cheap; it has a huge upfront cost. It involves underwriter's fees, accounting and legal fees, registration charges, printing charges, and advertising costs etc. Moreover, the accounting system and management have to be upgraded. You also need to find people who are qualified to sit in your company’s board.
Loss of Ownership Control:
Going Public means, you could lose ownership control of the business. If you somehow become a minor shareholder, the Board of Directors could even fire you.
Lower Control over Decision Making Process:
In a public company, any major decision needs to be passed by taking approvals from the majority of the shareholders. When you sell too much of your stakes outside the company, and your shareholders elect the majority of the board of directors, decision-making process may take days to complete or even be rejected in case of disagreement between broad of directors.
Increased Reporting Costs:
The Public companies have rolling costs for producing periodic reports and proxy statements that are filed with the regulatory authorities and distributed to the shareholders. Moreover, the company should perform periodic audits and practice all the other compliance procedures.
A public company is legally obligated to its shareholders to capitalize on shareholder profits and announce operational data. There is no way you can provide an excuse for any mismanagement. The company and its management can even be prosecuted for misrepresentations of information to shareholders or for omitting information that the country's securities laws require being disclosed.
Cons of IPO from the Company's View Point:
There is commonly a term, called as lock-in period, that restricts IPO investors from selling the share for the first 30-60 days. That's maybe a frustrating factor to investors if an IPO's value rises for few days and later falls below the IPO purchase value.
Should You Invest In An IPO?
Deciding whether to invest your money into an IPO of a comparatively new company is indeed a risky job. In this matter being conservative is a positive attitude to have in the stock market. Here list some of the points that you need to check before investing in IPO.
It is obvious that you won't get enough historical data to back your decision because it is just going to be publicly listed. You need to carefully scrutinize the data on the IPO details which is provided in the offering prospectus. Also, you need to search the internet to try to know about the management team and their future plans.
Who is Underwriting:
Underwriting is the first process to prepare for raising investments by issuing new securities. Be cautious of the underwriting by small investment banks. They may be willing to underwrite any new company. Typically, an IPO with a success potential is backed by big brokerage houses that have the ability and experience to endorse a new IPO issue.
A lot of time IPO takes a deep downtrend after the IPO is listed in public market. The reason behind this downfall of the share price is the lock-in period. A lockin period is a term which refers to a pre-defined period of time the company’s executives and investors are restricted from selling their shares. After the lock-in period ends, the share price undergoes a drop in its price due to initial selling pressure.
People who buy IPO stocks or shares of a newly listed company and sell off on the secondary market in order to make quick profits are called flippers. Flipping initiates the trading activity, brings heavy liquidity, and a sudden drop in share price. This is not much in control of you so don’t get panic due to falling price.
Things You Should Know Before Investing in IPO:
Remember stock prices are subjected to the volatility of the market. If you have invested in IPO of a company, you have related yourself to the fortunes of that company. You wealth have a direct impact on the company's success and loss.
It is the asset in your portfolio that has the highest potential either to reward the returns or to sink your investment without a sign. You should remember that a company which offers its shares to the public is not obligated to reimburse the capital to the public investors in case of losses.
You should measure the potential risks and rewards before investing in an IPO. If you are a beginner, read up statements from an expert or a good wealth management firm. If still in doubt, seek advice from your personal financial advisor.
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