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. A corporation whose securities are already trading publicly may also offer a new block of stock from its treasury stock or from a large investor in a secondary, or follow-up, offering. Another alternative is a direct public offering (DPO), a relatively uncommon practice in which a small company sells a limited number of its shares (less than $5 million) directly to investors rather than listing them on an exchange. Public offerings are in contrast to private offerings, in which a handful of individuals, many times with personal ties to the business owners or management, is approached directly with an offer to sell shares.
An IPO of common stock converts a business owned by one person or several persons into a business owned by many. Taking a company public serves two main purposes:
There are disadvantages, however. The registration process is expensive and cumbersome, and requires not only the extensive disclosure of the inner workings of the business but also intense scrutiny of the owners and executive officers. Sharing ownership also means dilution of earnings and loss of control.
Secondary public offerings and IPOs involve the transfer of wealth from suppliers of capital to demanders of capital in exchange for (1) direct ownership of the business through stock ownership, and/or (2) a claim on future earnings through debt securities.
Public offerings are thus a means for businesses to participate in the capital markets, which consist of a diverse set of firms that perform the function of bringing together the suppliers and demanders of capital. The primary U.S. marketplaces are the New York Stock Exchange, the Nasdaq Stock Market, and various smaller exchanges and other over the-counter securities markets.
Securities issuing and trading is highly regulated in the United States. The Securities Act of 1933 prohibited market players from unscrupulous dealings by requiring disclosure statements, and imposing criminal and civil penalties for inadequate and inaccurate disclosure of "material fact," i.e., information that would likely cause potential investors to reconsider the feasibility of the investment. In 1934 the Securities and Exchange Commission was granted the authority to implement and enforce the 1933 act.
The SEC is a quasi-judicial administrative agency authorized to regulate securities industry personnel and the trading of public companies. The SEC is responsible for a formal system of underwriting securities, offering them to the public, raising funds in the public markets, and supervising the continuing trading of securities. For very small securities offerings, often within one state, the issuing firm may not be required to register with the SEC; however, unregistered securities offered to general investors are regarded with great suspicion.
The SEC requires the education, testing, and licensing of individuals engaged in the sale of securities. To keep the investing public properly informed, the SEC has established a series of periodic reports to be filed by publicly listed companies. To oversee public offerings, the SEC has a long and involved registration, disclosure, and review process.
In order to prevent securities fraud, each state has legislation to prevent the sale of dubious investments, the proverbial one being an offer to sell the blue sky. The term "blue sky laws" generally refers to all state securities laws, and when a company has duly registered and complied with state laws, in addition to federal, it is said to comply with the blue sky laws. These laws are more or less similar to SEC rules and regulations, but there are some differences. Issuers of securities must comply with the blue-sky laws in each state in which they expect to offer the securities; if they are planning to be traded on a national market such as the Nasdaq, they effectively must comply with the laws of all 50 states.
The process of going public, i.e., making an initial public offering, is complex and costly. It begins with the process of incorporation, if necessary, for only corporations are publicly listed.
The corporation secures a financial adviser to consult on the feasibility of going public and in what manner to do so. After the decision has been made to go forward, the corporation seeks the services of a person who has access to funds. An investment banker serves as the liaison between investors and the company.
The company assembles an experienced team of accountants, auditors, and attorneys along with the investment banker. Together they complete and submit the registration forms and the initial offering prospectus required by the SEC. The prospectus provides a detailed discussion of the company, its performance and profitability, the management, and the intended uses for the funds raised.
Meanwhile, the company works with the underwriters to determine the appropriate offering price for the new securities, the underwriter's compensation, the size and timing of the offering, and the method of distributing the securities to the public.
The company and all of its team members are to honor a "quiet period" of 90 days from the date of commencing the work on the financial planning to the effective date of the registration statement. The SEC prohibits any publicity during the registration period other than the distribution of the preliminary prospectus. In practice, this means the company is not permitted to release publicity statements (e.g., drumming up interest in its shares) or other commentary about its impending offering up through the time it begins trading.
The SEC review determines the consistency and completeness of the statements to insure full disclosure of material facts. If incomplete, the company performs a "cleanup" to resolve SEC concerns.
In order to determine the public's interest in the IPO, the underwriter circulates an attention getter called a "red herring," whose cover page is printed in red as a warning that it is merely a preliminary prospectus. The red herring usually does not give an offering date, price, or number of shares but inside the red herring is a wealth of company information, financial statements, and notes.
Upon approval of the registration statements and the prospectus, the SEC notifies the company, and the security may then be listed on an exchange and sold to the public. SEC approval does not constitute a statement of investment merit or fairness of the offering price, but only that full disclosure of relevant facts has been made.
If there are changes to the initial prospectus, the company will revise, reprint, and redistribute it. Sales are permitted only after the potential investor has had a prospectus in hand long enough for adequate review. In the instance where only the price and share information is needed, the company merely sticks a completed label on the cover sheet.
The lead investment banker supervises the public sale of the security. For a larger offering, the lead investment banker will form a syndicate of other investment bankers to underwrite the issue as well as a selling group to assist with the distribution. During the offering period, investment bankers are permitted to "stabilize" the price of the security in the secondary market by purchasing shares in the secondary market. This process is called pegging, and it is permitted to continue for up to ten days after the official offering date.
After a successful offering, the underwriter meets with all parties to distribute the funds and settle all expenses. At that time the transfer agent is given authorization to forward the securities to the new owners.
An IPO closes with the transfer of the stock, but the terms of the offering are not completed. The SEC requires the filing of a number of reports (Form SR) that document the appropriate use of the funds as described in the prospectus. If the offering is terminated for any reason, the underwriter returns the funds to the investors.
Public offerings, especially those by innovative new companies, are extremely popular with many investors. In the 1990s this interest was fueled by a regular supply of Internet start-up companies whose unlikely shares enjoyed meteoric run-ups in the stock markets. While some IPOs earn their investors handsome returns, investing in new public offerings, particularly with new companies, is highly speculative and therefore entails a great deal of risk for investors.
Despite the risks, many investors clamor to get in on conventional IPOs and other kinds of public offerings. In the late 1990s, one area under exploration both by investment banks and government regulators was the use of the Internet for various nontraditional securities transactions, including direct public offerings and direct trading without use of an exchange. According to investor advocates, such immediate and relatively informal trading venues underscore the need for investor education to minimize the risk of falling for fraudulent deals.
[ Roger J. AbiNader ]
Arkebauer, James B., and Ron Schultz. Going Public. 3rd ed. Chicago: Dearborn Financial Publishing, 1998.
Halloran, Michael J. Venture Capital and Public Offering Negotiation. 3rd ed. New York: Aspen Law & Business, 1997.
Taulli, Tom. Investing in IPOs. New York: Bloomberg Press, 1999.