Initial public offerings
Initial Public Offering (IPO)
INITIAL PUBLIC OFFERING (IPO)
An initial public offering (IPO) takes place when a privately held company goes public and makes its first offering of shares to the public. It is a significant stage in the growth of a business. It provides the business with access to capital, not only through the IPO, but also through subsequent secondary stock offerings. For the company's founders and venture capital backers, an IPO can provide the opportunity to realize a substantial cash return on their early investments. IPOs also tend to generate a lot of publicity and create more interest in a company. Once a company has gone public, it can use its stock in acquisitions and mergers. Stock can also be offered to key employees and used to attract new talent.
Investors were attracted to the IPOs of high-tech and e-commerce companies in the last half of the 1990s. Many of those companies had yet to turn a profit, yet their IPOs were successful beyond all expectations. Investors appeared more interested in a firm's potential for success in the online world, as indicated by its market position or market share, and seemed willing to overlook its losses. This displacement of profitability by market potential in the eyes of investors was one phenomenon that led observers to develop the concept of the New Economy.
Although America Online went public in 1992, it was the hugely successful IPO of Netscape Communications in August 1995 that was credited with starting the investor craze for Internet start-ups that lasted until the end of the decade. Netscape's stock was first offered at $28 a share; it was worth $75 after one day of trading, and it peaked at $171 on December 5, 1995. The company's first-day market capitalization was $2.2 billion.
In 1996 it was the IPOs of Internet search engines that attracted the interest of investors. Yahoo!, Lycos, and Excite all went public in April 1996. Yahoo! sold 2.6 million shares at $13 per share on the NASDAQ. By the end of the first week shares more than doubled to nearly $33. Following its IPO Yahoo! had a market capitalization of more than $1 billion. Lycos raised $40 million with its IPO. Following their successful IPOs, other Internet companies announced plans to go public.
From mid-1996 through mid-1997 investors began to view electronic commerce companies more realistically, and relatively few high-tech or e-commerce IPOs were executed. Weak first quarter earnings in 1997 from established firms made investors more selective about buying new technology stocks.
MORE E-COMMERCE COMPANIES GO PUBLIC, 1997-1999
More well-known e-commerce companies began to go public in 1997. Online bookseller Amazon.com held its IPO in May 1997. The company sold 8 million shares at $18 a share after the market closed. The next day the stock opened at $27 a share and rose to $80 before closing at $25.50.
High-speed Internet access provider @Home filed for an initial public offering in May 1997 and went public in July. Its stock more than doubled on the first day of trading, from its initial $10.50 price to a high of $25.50 before settling at $19. The IPO gave @Home proceeds of $94.5 million and a market capitalization of more than $2 billion.
The success of Amazon.com 's and @Home's IPOs created an air of exuberance around high-tech and Internet IPOs that lasted for a couple of years. Neither Amazon.com nor @Home had shown any profits at the time of their IPOs, yet their stock increased in value following their IPOs. At the end of 1997 Internet advertising network DoubleClick filed for an IPO that took place in February 1998 and raised $62.5 million.
Online auction site eBay went public in September 1998 with an IPO that raised more than $60 million. When eBay held its IPO, investors quickly bid up the initial offering price of $18 to more than $54. After the stock settled down to around $47 a share, analysts noted that the valuation reflected consumer excitement over online auctions and investor awareness of the potential for profit. At the time most Internet ventures were losing money, but eBay managed to show a positive net income of $348,000 for the first six months of 1998.
The IPO market for Internet companies that had yet to turn a profit remained strong in 1999. With its venture capital running out, online retailer eToys turned to the public equity markets and held its IPO in May 1999. Eight percent of the company was offered to the public. Shares began trading on the NASDAQ on May 20, 1999, at $20 a share, raising $166 million for eToys. The stock rose as high as $85 on the first day of trading and ended the day around $76.50, giving eToys a market value of $7.8 billion, more than the $5.6 billion market value of established retailer Toys 'R' Us.
Priceline.com 's IPO on March 30, 1999, was one of the hottest Internet IPO's of the year. Interest in the IPO was so strong that Priceline.com was able to raise its IPO price twice before the offering, first from the original $7-$9 range to $12-$14, then to the final offering price of $16. The company raised about $115 million from the initial sale of shares at $16 each. By April 18 the stock reached nearly $60 a share. When the company announced on April 26 that more than 1 million customers had tried Priceline.com in its first year, the stock rose to $121 a share. Forbes noted that founder Jay Walker's initial $25 million investment in the company was now worth $4.3 billion.
In the area of online publishing and bookselling, BarnesandNoble.com and Hoover's Inc. both enjoyed successful IPOs in 1999. BarnesandNoble.com raised more than $430 million with its IPO in May 1999, selling more than 24 million shares at $18 a share. At the end of its first day of trading, BarnesandNoble.com had a market capitalization of $2.52 billion. Hoover's, a business information service, went public on July 21, 1999, with an initial public offering that netted $42 million for the company. For its fiscal year ending March 31, 1999, Hoover's reported revenue of $9.2 million and a net loss of $2.2 million.
Online research firm Media Metrix went public in May 1999 with an initial public offering that raised $51 million. In July 1999, 64 companies held their IPOs, making it the busiest month for IPOs since November 1997. The strong market for IPOs helped Internet companies such as Drugstore.com and MP3 more than double their stock prices on the first day of trading.
Among technology companies, the successful IPO of Red Hat, a seller of Linux software, in August 1999 helped to generate interest in Linux. The stock opened at $14 a share and climbed to more than $50 on the first day. The volatile stock later rose as high as $123 in September.
IPO SLOWDOWN BEGAN IN 2000
The IPO market remained strong in the first quarter of 2000. According to figures cited in Business Week, 33 Internet firms went public in January and February, with average first-day gains of 160 percent in January and 144 percent in February. IPO.com projected there would be more than 500 high-tech IPOs in the coming year, compared to 387 in 1999. The research firm did not know that conditions for high-tech and e-commerce IPOs would change dramatically during the year.
Buy.com 's IPO took place in February 2000. The company sold 14 million shares at $13 per share, raising approximately $182 million. Investors quickly bid the price up to $35 on the first day of trading before closing at $25.12 a share. Investor interest appeared to be unaffected by Buy.com 's failure to turn a profit. Although revenue for 1999 increased nearly fourfold to $296.8 million, the company's loss for the year was $130.2 million, compared to a loss of $17.8 million in 1998.
New companies in the business-to-business sector also attracted investor interest. WebMethods Inc., whose B2B software suite was based on XML, saw its shares increase 508 percent from $35 to over $212 on its first day of trading in February 2000. A month later the stock was trading at $240 a share. While the company's XML software generated a lot of interest, investors may have also been attracted by WebMethods' level of sales, clear cost savings for customers, and a demonstrable path to profitability.
While the IPO market remained strong through the first quarter of 2000, it finally cooled off in the second quarter of the year. Buy.com and other Internet companies that had gone public saw their stock prices fall to their IPO levels and below. Investors were becoming more concerned about the cash-flow problems and high cash-burn rates of online retailers. For the rest of 2000, a shakeout of dot.com companies took place, with many going out of business for a lack of funding. In November 2000, approximately 27 companies withdrew their IPO filings because of the weak market for IPOs, including PetSmart.com and CarsDirect.com.
Conditions for high-tech IPOs had not improved much when Loudcloud, an e-commerce solutions company started by Netscape co-founder Marc Andreessen, held its initial public offering on March 9, 2001. The unfavorable investment climate for Internet-based companies forced the company to lower its initial offering price. Instead of selling 10 million shares at $10 to $12 a share, Loudcloud had to sell 25 million shares at an offering price of $6 in order to raise the $150 million it needed.
As of mid-May 2001, only six technology-related IPOs had been executed in 2001, and none for e-commerce companies. In fact, no e-commerce company had held an IPO since 1999, according to VentureOne. One of the strongest technology offerings in 2001 was Instinet, which rose 22 percent on opening day. However, technology companies in general appeared to be waiting to launch their IPOs. According to IPO.com, only 11 companies went public in July and August 2001, and none in September. The drought in IPOs was attributed to several factors, including a general economic slowdown and market uncertainty.
Clancy, Heather. "Linux Lovefest on Wall Street." Computer Reseller News, August 16, 1999.
Dembeck, Chet. "Has the IPO Bubble Burst?" E-Commerce Times, August 6, 1999. Available from www.ecommercetimes.com
"E-Investors Embrace Business-to-Business." Business Week, March 6, 2000.
Hersch, Warren S. "IPO Market Shows Robust Performance." Computer Reseller News, July 28, 1997.
Marjanovic, Steven. "Internet Commerce Stocks Seen Headed for a Hard Landing." American Banker, May 18, 1998.
Regan, Keith. "PayPal to End IPO Drought." E-Commerce Times, October 1, 2001. Available from www.ecommercetimes.com
——. "Tech Stock Rally Raises Hopes for IPO Revival." E-Commerce Times, May 21, 2001. Available from www.ecommercetimes.com
Sloan, Allan. "Step Right Up." Newsweek, April 29, 1996.
——. "Trains You Can Miss." Newsweek, June 2, 1997.
Tracey, Brian. "Wall St. Throws Cold Water on Internet Commerce." American Banker, March 18, 1997.
SEE ALSO: New Economy; Shakeout, Dot-com; Volatility
Initial Public Offering (IPO)
Initial Public Offering (IPO)
An initial public offering (IPO) is the first (“initial”) sale of equity to the public by a private company, usually through investment banks. The private company thereby becomes a public company (it “goes public”).
The purpose of an IPO is to raise a substantial amount of equity capital and create a public market for company shares to be traded on stock exchanges. The funds raised can be used to finance various projects, such as the expansion of manufacturing, marketing, and research and development (R&D) activities. If a company needs to raise a large sum that cannot be financed by private investors, such as venture capitalists or banks, then an IPO might be the best, albeit a costly, way to obtain the necessary funds (the pecking-order theory ). The number of IPOs has fluctuated over time, but in some years, it has exceeded six hundred. According to Jay Ritter and Ivo Welch (2002), there were over six thousand IPOs during the 1980–2001 period, raising (in gross) $488 billion (in 2001 dollars). After the collapse of the dot.com bubble in 2000, the number of IPOs declined, but increased to 179 in 2004.
Once public, firms have direct access to the capital markets, enabling them to raise more capital by issuing additional stock in a secondary offering (a seasoned equity offering ). Public companies can also more easily raise funds privately.
Some insiders participate in the IPO by selling part of their shareholdings to receive possibly a substantial amount of cash and to diversity their portfolios. This can also be an exit point for many venture capitalists. Insiders can also sell their shares at later dates to convert their equity into cash.
An IPO is an expensive way to finance in three aspects: (1) the fees and expenses; (2) the change in ownership structure; and (3) the disclosure requirements. The underwriting fees (underwriting discount or gross spread ) alone in the United States amounted to 7 percent of the gross proceeds for 90 percent of the IPOs in the late 1990s, although the figures are lower in other countries (Chen and Ritter 2000). By going public, the previous owners (e.g., founders and venture capitalists) sell a slice of their company to dilute their ownership stake, which may reduce their ability to control the enterprise.
Firms must supply detailed information to the potential investors at the time of the IPO (in the registration statement, including a preliminary prospectus—commonly called a red herring —and the final prospectus). This requires costly preparation of reports, as well as possible disclosure of strategic and sensitive information to competitors. Subsequently, firms operating in the United States are required as public companies to file quarterly and annual reports with the Securities and Exchange Commission (less frequently in some countries).
Most IPOs are offered to the public through an underwriting syndicate, consisting of a number of underwriters who agree to purchase the shares from the issuer to sell to investors (best effort or firm commitment). The lead underwriter usually sets the basic terms and structure of the offering, including the allocation of the shares and the offering price. Syndicate members do not necessarily receive equal allocations of securities for sale to their clients. Most underwriters target institutional or wealthy investors in IPO allocations, since they are able to buy large blocks of IPO shares, assume the financial risk, and hold the investment for the long term. Since “hot” IPOs are in high demand, underwriters usually offer those shares to their most valued clients.
IPO companies tend to be young and small companies that lack a long-established record of profitable operation. The median age (from the year of founding) of IPO firms is seven years (Ritter 2006). Roughly one-third of IPO firms reported losses in their IPO prospectuses before going public, although being profitable used to be standard (Ritter and Welch 2002). Ritter (2006) reports that 34.3 percent of IPOs are technology companies, of which 60.6 percent were backed by venture capitalists (compared to 39.9 percent of all IPO companies) for the 1980–2003 period. Therefore, investors purchasing stock in IPOs generally must be prepared to accept large risks for the possibility of large returns.
It is often observed that IPO shares open at a slightly higher price and close at a substantially higher price than the offering price at the end of the first of day of trading (providing a significant return to the IPO participants with the allocated shares). This phenomenon is referred to as IPO underpricing or leaving money on the table and is observed not only in the United States, but also in other countries. A price run-up on the first day occurs when the demand exceeds the supply (the IPO is “hot” or the offering is underpriced).
The first-day return averaged 18.8 percent (the average daily market return is 0.05 percent) during the two decades prior to 2001. It decreased with the collapse of the bubble, but is still substantial at 12.1 percent. Although the first-day return is typically positive, IPOs have in general underperformed in the long run both in terms of stock returns and financial accounting results. Ritter and Welch (2002) report that the average three-year buy-and-hold returns (from the closing price of the first day) of IPOs underperformed by 23.4 percent (compared to the CRSP [Center for Research in Security Prices] value-weighted market index) and by 5.1 percent (compared to seasoned companies with the same market capitalization and book-to-market ratio). Smaller firms (in terms of sales prior to an IPO) appear to do much worse. Underpricing and poor long-run performance do not appear to be related in a systematic manner, however. Why do firms leave so much money on the table? Why do so many IPOs underperform? These questions are important subjects of academic inquiry in finance.
The academic accounting literature documents that many IPO firms engage in earnings management through an aggressive use of (discretionary) accruals to inflate reported earnings around the time of the IPO. Long-run underperformance is more pronounced for firms with more aggressive discretionary accruals (Teoh et al. 1998). Some IPO firms in R&D-intensive industries reduce R&D expenditures below the optimal level to increase reported earnings (Darrough and Rangan 2005). These findings suggest that some managers try and sometimes succeed to influence the perception of investors of IPO firms by manipulating accounting numbers.
Chen, Hsuan-Chi, and Jay Ritter. 2000. The Seven Percent Solution. Journal of Finance 55 (3): 1105–1131.
Darrough, Masako, and Srinivasan Rangan. 2005. Do Insiders Manipulate Earnings When They Sell Their Shares in Initial Public Offerings? Journal of Accounting Research 43 (1): 1–33.
Ritter, Jay, and Ivo Welch. 2002. A Review of IPO Activity, Pricing, and Allocation. Journal of Finance 57 (4): 1795–1828.
Ritter, Jay 2006. Some Factoids about the 2005 IPO Market. Working Paper. http://bear.cba.ufl.edu/ritter.
Teoh, Siew Hong, Ivo Welch, and T. J. Wong. 1998. Earnings Management and the Long-Run Market Performance of Initial Public Offerings. Journal of Finance 53 (6): 1935–1974.
Masako N. Darrough
Initial Public Offering
Initial Public Offering
An initial public offering (IPO) is the process through which a privately owned business sells shares of stock to the public for the first time. Also known as going public, an IPO provides a growing business with access to public capital markets and increases its credibility and exposure. It has long been considered a rite of passage that marks an important phase in a business's development. At the same time, however, staging an IPO is both time consuming and expensive. It requires companies to navigate a complex Securities and Exchange Commission (SEC) registration process and disclose a great deal of confidential information to potential investors. Furthermore, the success of an IPO is not guaranteed, and depends in part upon industry, economic, and market conditions that are beyond a company's direct control. Overall, the decision to go public is a complicated one that requires careful management consideration and planning.
There is no doubt that becoming a public entity offers a number of advantages to a business. In addition to gaining immediate access to capital to fund expansion, it also makes it easier for the firm to obtain capital in the future. The IPO process provides a company with a great deal of publicity, which may help increase its credibility with suppliers and lenders, attract new customers, and create new business opportunities. Going public also offers an opportunity for the company's founders and venture capitalists to cash out on their early investments, and provides a public valuation of the company to facilitate future mergers and acquisitions.
Some of the major disadvantages associated with going public include the high cost of staging an IPO (which may claim 15 to 20 percent of the proceeds from the stock sale), the demands on the time of managers (the process may take between six months and two years to complete), and the dilution of ownership and associated loss of management flexibility and control. In addition, the process of going public requires a private company to disclose confidential information about its strategy, capital structure, customers, products, competitors, profit margins, and employee compensation. Finally, becoming accountable to shareholders sometimes leads to an increased emphasis on short-term financial performance.
The first step in the IPO process involves applying to the SEC for permission to sell stock and preparing an initial registration statement according to SEC regulations. This statement includes a prospectus of detailed information about the company, financial statements, and a candid management analysis of the risks and benefits of investing in the company. The next step involves selecting an underwriter—usually an investment bank—to act as an intermediary between the company and the capital markets. The underwriter helps determine the valuation of the company and the suggested share price. It also helps assemble an underwriting team, which includes attorneys, accountants, and financial printers.
While the SEC completes its review of the registration statement—a period of time known as the cooling off or quiet period—the company undergoes an audit by independent accountants, files forms with the states where the stock will be sold, and begins marketing the investment to potential investors through road shows featuring top executives. Once the SEC review is complete, the company finalizes the registration statement, files a final amendment with the SEC, and agrees to an asking price for the shares of stock. Then the sale of stock finally takes place, overseen by the underwriter. Afterward, the underwriter meets with all involved parties to distribute funds from the sale, settle expenses, arrange for the transfer of stock, and file final reports with the SEC.
The pace of IPOs peaked in 1999, fueled by investor interest in Internet-related businesses. It declined markedly in 2000, as a drop in the value of technology stocks led to an overall drop in the stock market. Over the next few years, investors largely adopted a more cautious, back-to-basics approach toward IPOs. They increasingly demanded that companies demonstrate a proven business model, solid management team, large customer base, and strong revenue potential if they hoped to stage a successful
IPO. Another factor limiting the number of IPOs was the Sarbanes-Oxley Act (SOA) of 2002. Passed in the wake of several high-profile corporate accounting scandals, the act required the boards of public companies to include independent directors with financial experience. It also required public companies to form auditing committees chaired by an outside director. As a consequence of Sarbanes-Oxley, companies who are “IPO ready” are now larger and more established than in the past.
SEE ALSO Cash Flow Analysis and Statement; Due Diligence; Entrepreneurship; Financial Issues for Managers; Strategy Implementation
Evanson, David R. “Public School: Learning How to Prepare for an IPO.” Entrepreneur October 1997.
Feldman, Amy. What Does Sarbanes-Oxley Mean for Companies That Want to Go Public? Inc. Magazine September 2005.
Feldman, David. Reverse Mergers: Taking a Company Public Without an IPO. New York: Bloomberg Press, 2006.
Kleeburg, Richard F. Initial Public Offerings. South-Western Publishing, 2005.
Quittner, Jeremy. “Private Matters: IPOs Move Further Out of Reach.” Business Week 1 November 2004.
Rittenberg, Larry, and Patricia Miller. Sarbanes-Oxley Section 404 Work: Looking at the Benefits. Altamonte Springs, FL: Institute of Internal Auditors, 2008.
Vallone, Paul. “IPO Checklist: Preparing Your Company for Public Markets.” San Diego Business Journal 23 February 2004.
Welch, Ivo. “IPO: The Initial Public Offerings Resource Page.” Available from: http://www.iporesources.org/ipopage.html.
Initial Public Offering (IPO)
INITIAL PUBLIC OFFERING (IPO)
In order to raise capital, corporations offer their securities for sale to the general public. An initial public offering (IPO) is the first instance in which a corporation offers a specific, registered security for sale. An IPO of common stock converts a business owned by one person or several persons into a business owned by many. This practice provides an immediate injection of cash which can be used to increase the company's prospects of growth and expand its equity base, increasing the possibility of stock value appreciation.
Corporations must go through the red tape of registration with the Securities and Exchange Commission (SEC), which sets standards and regulations for the investment market, before any offering can be made. In this process a corporation must reveal extensive information about its inner workings, develop an initial offering prospectus (a detailed brochure about the corporation's performance, management, and plan of use for the funds raised), and determine the price at which the new security will be offered on the market. Once the SEC has given its approval, the initial public offering may go forward.
See also: Appreciation, Equity, Securities and Exchange Commission, Stock