What is an Initial Public Offering (IPO)?

Most startups aspire to expand and grow, often turning to Initial Public Offerings (IPOs), to achieve their goals. This article will delve into the concept of an IPO, its mechanics, and the steps involved in the process.

 What is an Initial Public Offering (IPO)?

It is the process through which a private company offers its shares to the public for subscription, by providing them for sale to the public. This can be a growth strategy for both emerging startups and well-established businesses.

How Does an IPO Work?

A private company’s first public sale of shares is known as an initial public offering (IPO). The business can thus raise funds.

To do an IPO, the company must define its investment objectives, financial strategy, the amount of capital it seeks to raise, and the number of shares it will issue. Then, it hires a bank to help sell the shares to investors.

How is an Initial Public Offering (IPO) priced?

Investment banks, typically responsible for marketing the shares, determine the pricing. Several factors influence this decision, including the company’s objectives, strategies, and future growth potential. Since new companies are often going public, there might not be a long history of earnings to look at. So, they compare it to similar companies that are already on the stock market.

What’s the goal of a company going public?

An IPO is a method through which a company raises capital by offering its shares to the public for the first time.

The main reason a company does this is to get the cash it needs. This money can be used to pay off debts, combine with other businesses (mergers), or buy out other companies (acquisitions).

Steps of an Initial Public Offering (IPO)

A company must follow several key steps to successfully conduct an Initial Public Offering (IPO). These steps are as follows:

1. Selecting an Underwriter: company must choose a suitable investment bank to act as an underwriter. This financial institution will provide expert advice on all aspects of the IPO and will often purchase the shares from the company and sell them to the public. The chosen underwriter should have a strong reputation and extensive experience in IPOs, ideally with a pre-existing relationship with the company.
2. Registration and Prospectus Filing: company must file a registration statement with the relevant securities regulatory authority. A draft prospectus, often referred to as a “Red Herring,” is also prepared. This document contains detailed information about the company, its financials, and the IPO itself.
3. Regulatory Approval: The securities regulatory authority, such as the Securities and Exchange Commission (SEC) in the United States or the Saudi Capital Market Authority (CMA) in Saudi Arabia, reviews the registration statement and prospectus. Once the regulator is satisfied with the information provided, it approves the IPO.
4. Exchange Listing: company applies for a listing on a stock exchange. This involves meeting the exchange’s specific listing requirements and paying the necessary fees.
5. Marketing the IPO: company and its underwriter conduct a marketing campaign to generate interest in the IPO among potential investors. Roadshows, presentations, and other marketing activities might be involved.
6. Pricing the Shares: company and its underwriter determine the offering price for the shares. This is typically done through a process known as book-building, where investors indicate their interest in purchasing shares at various prices.
7. Allocating Shares: Once the offering price is set, the underwriter allocates shares to investors based on their orders. Overallotment is often used to stabilize the share price in the aftermarket.

Benefits of an Initial Public Offering (IPO)

An Initial Public Offering (IPO), where a company offers its shares for public sale, provides numerous advantages, including:

• Increased Capital: IPOs allow companies to raise significant amounts of capital, which can be used to pay off debts, fund research and development, or expand operations.
• Enhanced Company Visibility: Listing shares on a public exchange significantly boosts a company’s profile and visibility among investors.
• Improved Corporate Reputation: By going public, a company can enhance its reputation and credibility with stakeholders such as suppliers, distributors, and customers.

The Drawbacks of an Initial Public Offering (IPO)

When we initially explored the question of what an IPO is, you were likely driven by curiosity. After learning about the advantages of an IPO and its significance, you may now feel a sense of excitement. However, it’s important to understand that, like any investment, IPOs have their drawbacks. The company issuing shares in an IPO faces several challenges, including:

• High Costs: Companies undertaking an IPO incur substantial legal, accounting, and marketing expenses.
• Increased Time and Effort for Management: The company management must dedicate significant time and effort to preparing regular financial reports.
• The emergence of agency problems: conflicts of interest between management and owners.

Can anyone invest in an Initial Public Offering (IPO)?

Typically, the demand for shares in an IPO exceeds the supply, so not all investors can acquire IPO shares. It is worth noting that most investors purchase IPO shares through available brokerage firms.

What are the potential risks for investors participating in an Initial Public Offering (IPO)?

Investing in an IPO presents several risks for investors. Here are two key concerns:

• Lack of Information and Company Maturity: Newly public companies often have limited operating history and publicly available financial data. This lack of information can make it challenging for investors to conduct thorough due diligence and accurately assess the company’s prospects.
• Overvaluation Risks: IPOs are frequently accompanied by heightened market hype, which can lead to overprice share. If the market’s expectations for the company are not met, investors who purchase shares at the IPO price may experience significant losses.

Examples of Successful IPOs

• Saudi Aramco: Saudi Aramco stands as one of the world’s largest companies. The company’s initial public offering (IPO) took place in December 2019. In the initial offering, Aramco sold 3 billion shares for a staggering $25.6 billion. The company later sold an additional 450 million shares, making it the largest initial public offering in history. Notably, the company is involved in the exploration, production, transportation, and sale of oil and gas.
• Alibaba: Alibaba shattered all previous records for initial public offerings in 2014, raising a staggering $25 billion from its IPO. The company is a major player in the global e-commerce industry.
• Adani Wilmar: Adani Wilmar stands out as one of the most successful IPOs. Its share price closed at ₹265.2 during the IPO, significantly higher than the initial offering price of ₹230. The company produces consumer goods such as edible oil and processed food.
• Venus Pipes and Tubes: it set its initial share price at 326 rupees, but it quickly rose to 335 rupees on the Bahrain Bourse. Venus Pipes and Tubes is involved in the manufacturing of steel pipes and tubes.
• Droneacharya Aerial Innovations: company experienced a remarkable 150% surge in its share price within a short period. Droneacharya is an organization that manufactures drones.

Examples of Companies that Failed in Their IPOs

• TheGlobe.com: TheGlobe.com’s IPO failure is considered one of the worst crises of 1998. On the first day of trading, the share price skyrocketed by nearly 600%, raising approximately $27.9 million. However, shortly after, the New York Stock Exchange delisted the shares due to the company’s failure and the subsequent decline in its share price to less than one dollar.
• Pets.com: The IPO of Pets.com is regarded as one of the worst in history. The company’s rapid collapse was particularly striking, as it filed for bankruptcy only nine months after its initial public offering.
• Paytm: Paytm is another company that faced a failed IPO. Its share price plummeted by around 27% on the listing day. The primary reason for this loss was the presence of strong competitors in the market.
• LIC: LIC incurred significant losses in 2022. The share price was initially set at 872 rupees but soon dropped to 867 rupees. Currently, LIC shares are trading at around 547 rupees per share.
• Disclaimer: We do not promote stock investments. We advise investors to research the Islamic rulings of stock investments before purchasing shares. For more information, please refer to: The Islamic Ruling on Purchasing IPO Shares.

Read more: Stock Market 101: A Beginner’s Guide to Investing

• How do I buy shares in an Initial Public Offering (IPO)?
  To purchase shares in an IPO, you need to understand more than just what an IPO is. It’s essential to carefully read all the information provided above. Whenever you’ve done that, you can continue with the following steps:
  First, you’ll need to open a brokerage account and fund it. You’ll also need to meet the eligibility requirements to buy the offered shares. Then, you’ll submit a purchase order through your broker. Your broker will then buy the requested shares for you, provided they are still available.
• Will I always make money if I invest in an IPO?
  Not necessarily. A lot of the time, companies’ stocks are priced too high right at the start. This can cause the price to drop after the IPO and losses for investors.
• Which of the previous IPOs was the largest ever?
  The largest IPO was by Alibaba Group, which raised approximately $22 billion.

References:

• https://www.samco.in/knowledge-center/articles/famous-ipos/
• https://www.indiainfoline.com/knowledge-center/ipo/ipo-process-in-india
• https://www.forbes.com/advisor/au/investing/what-is-an-ipo/
• https://economictimes.indiatimes.com/definition/ipo
• https://www.british-business-bank.co.uk/finance-hub/ipo/