This paper outlines the typical initial public offering process in the United States (U.S.).  It is important to note the U.S. has the most stringent laws and requires the more disclosures than any other stock market in the world.  Therefore, a public company that is listed in the U.S. stock market such as New York Stock Exchange (NYSE) is also viewed as prestigious. The purpose of this paper is to analyze the process of a typical IPO. This includes choosing underwriters to post IPO activities such as stabilization activities. Moreover, this paper compares and analyzes the traditional IPO versus the auction style IPO.  The goal of this paper is clarify the IPO process and provide insights into this complicated, but interesting milestone in the life cycle of companies. The completion of this process will have provided a new capital for the firm, and a new investment opportunity for the public.

Underwriter Selection and Role

The first step in the road towards an IPO is to choose an investment banking firm that can guide and advise the company through the underwriting process.  There are many investment banking firms which specialized in taking company public. Some of the reputable firms are JP Morgan, Solomon Smith Barney, Piper Jaffrey and Goldman Sach.  In selecting the right firm, the company must consider several factors. 

The general reputation of the investment banker is important in order to instill confidence in potential investors.  Choosing a firm that is known to provide quality research and coverage is ideal.  Whether the investment banking firm is respected in the industry is important.  For instance, it would not be prudent to select an investment banker that has no prior experience in the company’s industry. 

The investment banker is also selected based on prior banking experience with the company.  In some cases, key board members might already have a pre-existing relationship with the banker.  This is common where the company is partly owned by venture capitalist.  The selection process is a two way affair with the investment banker also choosing its client carefully to ensure initial fees can be recovered and that the company is financial solid to make it through the process (Hambrecht, 2002).

Whether or not the company would like its securities held by individual or by institutional investors is another important consideration. Firms that have access to a large pool of investors are ideal. In a typical IPO, 80 percent of the shares are designated towards large institutional investors and the remaining is offered to retail (Lowry & Schwest, 2003).

Large public offerings are usually managed by multiple managers. When there are multiple managers, one investment bank is selected as the lead manager.  The managing underwriter makes all the arrangements with the issuer, establishes the schedule of the issue, and has the primary responsibility for the due diligence process, pricing and distribution of the stock. The lead manager is also responsible for assembling a group of underwriters (the syndicate) to assist in the sale of the shares to the public (Lowry & Schwest, 2003)

SEC Registration

Once the investment banker(s) have been selected, the next step is to work with the underwriter to file a registration with the SEC.  The filing is mandated by the Securities Act of 1933. The purpose of the registration and disclosure requirements is to ensure that the public has adequate and reliable information regarding securities that are offered for sale. The registration statement consists of two parts: the prospectus, which must be furnished to every purchaser of the securities, and “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC (“Guide to Going Public”, PWC, 1999).

As part of the registration process, the underwriter has a “due diligence” requirement to investigate the company and verify the information it provides about the company to investors. It is important to note the SEC has no authority to prevent a public offering based on the quality of the securities involved. It only has the power to require that the issuer disclose all material facts. As a safeguard, the Securities Act requires that the registration statement be signed by the directors and principal officers of the issuer as well as the underwriters, accountants, appraisers and other experts who assisted in the preparation of the registration statement. (Wikipedia, n.d) Any purchaser of the securities who is damaged as a result of a misstatement or omission of a material fact in the registration statement may sue these signatories.  In general, securities sold in the U.S must contain the following registration information (Lowry & Schwest, 2003):

• Description of the company's properties and business.
• Description of the security to be offered for sale.
• Information about the management of the company.
• Financial statements certified by independent accountants.

Red Herring

Once the registration statement is filed with the SEC, it is transformed into the preliminary prospectus or “Red Herring”. The preliminary prospectus is one of the primary tools in marketing the issue (“Guide to Going Public”, PWC, 1999). During this period, the SEC examines the registration statement and engages in a series of communications with issuer’s counsel regarding any changes necessary to bring about SEC approval. If the changes are minor, they are included in the “price amendment”; if the changes are extensive, a new prospectus is prepared and distributed. This process of review and modification usually occurs within a period of 20 days (“Guide to Going Public”, PWC, 1999). Once the “Red Herring” is amended, it is transformed into a prospectus, which is the official offering document. The final prospectus contains detailed overview of the company's finances, history, operations, products, risk factors, industry environment, and other information.

Road Show

Once the registration statement is approved by the SEC, the marketing of the offering officially begins. This phase is commonly known as the “Road Show”.  When the issuer and its underwriters go on the road show before the offering, they presumably have two main objectives. They wish to market the issue to potential investors, and they seek to obtain more information on the true value of the firm.

During this process, the official prospectus is sent to sales people as well as to institutional investors around the country. A typical road show lasts 3 to 4 weeks and includes two or more meetings a day with both retail salespeople and institutional investors.  As the road shows progresses, the underwriter receives indications of interest from investors (Lowry & Schwest, 2003).

The indications of interest by individual investors and by institutions will normally differ along several dimensions. First, retail investors typically submit a “market order” in which only the quantity desired is stated. Institutions, on the other hand, typically submit limit orders where the quantity demanded is subject to a maximum price. Second, retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders. Third, in some cases, institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled. These differences in turn may affect the investment bank marketing strategy. However, regardless of the rate of interest, shares can be officially sold, so any orders submitted are only indications of interest and are not legally binding. (“Guide to Going Public”, PWC, 1999).

Pricing

Once the underwriter and the issuer are able to gauge the interest of the offering, the process of determining share price and the number of shares to offer is the next step. The share price and number of shares to offer are inter-related as the number of shares to be sold has a direct influence on the price.  In many respect, the process of pricing is initiated when the issuer and underwriter starts the road show.

Although the process of pricing a new issue is complicated and can differ depending on the underwriter, there are some common tactics that exist.  First, the firm and its underwriters agree on a range of prices within which they expect to set the offer price.  The price range is determined by the sentiment gained from the road show.  The goal of this process is to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company.

The underwriter and issuer must be careful not to overprice the stock.  If a stock is offered to the public at a higher price than what the market will pay, the underwriters may have trouble meeting their commitments to sell shares. Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it may lose its marketability and hence even more of its value. For this very reason, it is much better to slightly under price an IPO.  The second stage of the pricing process typically occurs after the market closes on the day before the offering, when the company and its underwriters set the final offer price.   This is the price at which the issue is offered to the public.  Finally, the true value is determined when the issue starts trading on the stock market (Lowry & Schwest, 2003).

Determining a Share Price and Number of Shares

          As previously discussed, with traditional IPOs, Wall Street underwriters determine the number of shares that will be sold and set the price of those shares (“The Buzz on Google’s IPO”, 2004).  This information is presented to the issuing firm by the underwriter and a share price is concluded.  This traditional method has allowed favored customers of investment houses to benefit from this arrangement, resulting in many IPO stocks soaring on the first day of trading and yielding large profits for the early, fortunate buyers.  Therefore, in this method, underwriters have an “incentive to lowball the value of the firm.  Underwriters want to satisfy their customers who buy large blocks of IPOs.  The underwriters want to make sure these investors make money right away and that they come back to buy future IPOs” (“The Buzz on Google’s IPO”, 2004).  While the underwriters get paid by the issuing firms, they are essentially looking out for themselves.  The traditional method of bestowing the underwriter with the power to determine the number of shares that will be sold and set the price of those shares has some obvious flaws and this fact has led to some recent shifts in approaching how IPO share pricing and the number of shares is determined, such as the auction style IPO approach which will be discussed later in detail.

Typically, an IPO will have a price range of approximately $12 to $14 per share but if the offering is red-hot, it could be as much as $22 to $24 per share (“IPO Newsdesk”, 2004).  There are a few occasional exceptions such as Google who decided to sell its price range in the triple digits and initially offered shares from $108 to $135 (Taulli, 2004) and (Joyce, 2004). 

Quiet Period

An IPO “quiet period” is the time in which an issuer is subject to a SEC ban on promotional publicity (“Quiet Period”, n.d.).  During the quiet period, insiders and affiliated underwriters are restricted from issuing earnings forecasts and research reports (Bradley, et. al, n.d.).  In other words, a company can take itself public but cannot discuss its stock with anyone during these months.

The quiet period usually lasts either 40 or 90 days from the IPO (“Quiet Period”, n.d.).  However, this time frame is a recent change in the U.S. stock market.  Previously, the quiet period was for approximately 25 days (Bradley, et. al, n.d.).  In June of 2005, the SEC abandoned the “quiet period rule” by allowing companies to promote the securities to investors when they are in an IPO position (“SEC could relax”, 2004).  The 5-0 SEC commissioner vote on this topic allowed companies to distribute written material (in addition to the prospectus) about securities for sale and to sponsor presentations to the public (Matthewson, 2005). 

This decision changed a rule that was established during the Depression-era came about largely in part to the changing climate during the Internet boom era.  During this time, many high tech companies found that their revenues could triple in the period between filing the S1 with the SEC and meeting with potential investors, unlike the old days when revenue streams remained largely unchanged within this period (“Investor relations”, 2000).

According to the 2005 SEC Chairman, William Donaldson, “The package that we consider today will modernize the securities offering and communication process while maintaining investor protections…investors are entitled to information at the point they commit to purchase a security” (Matthewson, 2005).  The new rule is not a blank check; any public statement must be accurate, not misleading, and must coincide with the legal standards that apply to a company’s prospectus.  Commissioner Harvey Goldschmid suggested that this new rule would “create a quiet revolution and make capital formation in the United States far more efficient” (Matthewson, 2005).  While this is still yet to be seen, changing the quiet period rule certainly altered the communication strategies of companies rolling out IPOs.

Stabilization Activities

The stabilization process begins after the stock is available for trading.  What takes place during this time is an IPO’s lead underwriter or lead manager gets involved in the market by placing buy orders at specific prices in order to prevent a new issue from falling below its IPO offer price (“Stabilization”, n.d.).  Stabilization activities are intended to ensure that the IPO does not fall below its offer price.  Essentially, stabilization is a legalized form of market manipulation.  The practice of stabilization is intended to protect the issuer’s stock and is therefore sanctioned by the SEC (“IPO and VC Qestions and Answers”, n.d.). 

According to the SEC, price stabilization is defined as “transactions for the purpose of preventing or retarding a decline in the market price of a security to facilitate an offering” (SEC release, 1996).  The SEC allows stabilization activities to transpire because although it is a price- influenced activity intended to induce others to purchase the offered security, “when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers” (SEC release, 1996).  While some stabilization activities have been criticized for being used as “penalty bids” that discourage immediate resale or “flipping” of IPO shares, particularly by retail investors, stabilization activities are largely accepted in the IPO process and financial industry (Ibbotson, Sindelar, and Ritter, 1994).

     Some stabilization activities include: pure stabilization, syndicate short covering and penalty bids, but the SEC only regulates the first (Aggarwal, 2000).  In pure stabilization, the lead underwriter posts a stabilizing bid, visible to all market participants.  These bids are “no higher than the lower of the offering price and of the level of any independent bid…[and] not above the offering price” (Jenkison, et. al, 2006).  The SEC limits pure stabilization to the period before the distribution has been completed; therefore, frequently underwriters avoid using this stabilization technique because it calls attention to the fact that the distribution is incomplete and alludes to a weak aftermarket.  In short covering stabilization, the underwriter allots more shares to the investor than they receive from the issuers (Jenkison, et. al, 2006).  Short covering is not regulated by the SEC.  The third type of stabilization is the use of penalty bids, where the lead underwriter withholds selling concession from underwriters whose customers flip shares in the immediate aftermarket (Jenkison, et. al, 2006).  In essence, the stabilizing effect of penalty bids is deterrence. 

The important thing to note in regards to stabilization is that having a plan on how to approach stabilization in the IPO process and pre-determined strategies is imperative.  When a company is considering engaging in an IPO, a stabilization plan is a component that is necessary for a company to think through and plot specific strategies.

Cost of IPO

The business cost of an IPO can be a bit staggering.  In 2004 the median IPO issuer paid approximately $1.9 million (“IPO News Desk”, 2004).  (This estimated cost of going public is heavily weighted by pre-IPO companies because many that begin the process invest initial funding into the activity but never successfully complete the IPO.)  Therefore, it is imperative for a company to weigh the expense of engaging in an IPO against the potential amount of new capital that can be raised from the public offering.  Some activities that contribute to the expense of an IPO include the cost of having a company’s accounts audited, the need to contract lawyers who are up to date with the ever changing rules and regulations, and the financial printer’s bill (“IPO News Desk”, 2004). 

Benefits of IPO

An IPO is a grueling and expensive undertaking that offers no guarantee of success.  Therefore, it is important for a company to analyze the benefits of an IPO and honestly evaluate their reasons for going public.  Some reasons why a company should go public include “to obtain funding; for owner(s) to gain personal wealth (i.e. as an exit strategy); to raise the company’s profile, gaining awareness and attention; to build a company for the long haul, as opposed to a ‘flip’ in the near term; or for ego, to allow the owner(s) to ‘join the club’” (Currie, n.d.). Ibbotson If a company has large amounts of revenue, ongoing needs for vast amounts of capital and they can benefit from the visibility of being a publicly traded company, they should consider the IPO route.  Although the most notable benefit of an IPO is raising capital, the issuing firm can also take pride in the sense they are providing the investment community another opportunity to invest.

Traditional IPO vs. Auction Style IPO

There are four primary differences between traditional IPOs and auction style IPOs.  The first difference is in regards to how customers participate in the offering.  In traditional IPOs, customers submit interest indications.  In auction style offerings, customers submit bids.  Secondly, from the time a bid is placed in an auction offering, the customer is committed to a limit price, the price at which they are comfortable paying.  That limit price is combined with other customer bids to determine the highest price in which the IPO issuer will distribute all shares offered.  In the traditional IPO process, share prices are determined by underwriters and are established independently of customer input or bids.  Third, there is a difference in how the shares are allocated.  In the traditional IPO model, allocations are based on many factors such as length and nature of the relationship with the issuer and the interest level of participation.  In the auction style approach, the clearing price is determined by the combined average of the limit price bids.  Then, if a bid is above the offering price, the customer will receive the number of requested shares and if the limit price is below the offering price, no shares will be awarded.  The fourth differentiating factor is that in the traditional model customers must confirm their interest after effectiveness for all bids.  In the auction style model, a customer does not have to confirm their bid (“About Open IPOs”, n.d.).

Google made a clever move in regards to setting their IPO share price and number of shares.  Google decided to bypass Wall Street’s investment banking middlemen by offering a “Dutch auction” style IPO which would offer two classes of stock by using the Internet to “disseminate and price its shares, thus making more stock available to more people and avoiding the hefty 7% fee that investment banks typically charge to take a company public” (“The buzz on Google’s IPO”, 2004). 

Google decided to offer two classes of stock (Class A and Class B) which places much power in the hands of the corporation’s management.   Google’s SEC filings state that academic studies have found that “purely from an economic point of view, dual class structures have not harmed the share price of companies.  The shares of each of our classes have identical economic rights and differ only as to voting rights” (“The buzz on Google’s IPO”, 2004).  Google was able to make this new action style IPO approach to share pricing and number of shares offered work largely because they had established robust revenue and profitability, and established brand and a keen skill of employing media to disseminate their message, even during prohibited “quiet period” times.

          The auction style IPO approach is a viable one for companies in a position such as one that Google was in.  The auction style approach allows a company to discover their value as defined by the public rather than having to bear the burden of calculating an educated guess regarding their value and assigning a strategic price tag.  Today, companies seem to prefer a “book building process”, the auction style IPO, because this process allows for price discovery (Chakravarty, 2005).

Conclusion

Taking a company public is a major milestone for any organization.  Issuing an IPO is a complex process but is a method that can present great opportunities for corporation growth such as raising capital and increasing visibility.  IPOs are unique stocks because they are newly issued and have no performance track record and therefore exhibit great risk and great potential reward (“Quiet Period”, n.d.). 

This paper analyzed the process of a typical IPO in the U.S., including the underwriter selection and process and the steps required to register an IPO with the SEC.  How companies market the IPO is a dynamic and imperative process including functions such as publishing the prospectus, participating in a road show, and strategically delivering media messages even during a quiet period.  When considering and IPO, it is important for businesses and their appointed underwriters to carefully research and set the share price at a competitive rate.  One new and increasingly popular method of doing this is employing an auction style IPO where share prices can be determined via discovery.  While offering an IPO can be very costly, it can also present numerous benefits for a company that may not be achieved by other activities.   

In conclusion, this is a cursory look at what it takes for a company to go public, insights into the complex process, the necessary motivating factors for offering an IPO, and the many benefits that can result from making this monumental step in any business cycle.

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