How IPOs Work
We frequently get questions about IPOs. The ones that skyrocket on their first day of trading make investors wonder why all of them don't rise that much. Meanwhile some investors put in orders for an IPO stock, and end up overpaying, or failing to "catch the ride." We also get a lot of questions wondering how a stock can IPO at $15 but cost $60 on its first trade. Here's an explanation of how IPOs happen, and some suggestions for those wanting to get in on IPO day when you aren't part of the IPO.
The Company Decides to Go Public
The first step, of course, is that a company decides to raise capital by selling shares in a public offering.
To do this, it generally must have passed a certain level of "certification." In the old days, this meant that a company had proven its business model, shown good growth, had a reasonable business purpose for the capital, and generally had at least $10 million in revenues. And, oh yes, was profitable.
The bar was lowered considerably in the late 1990s as capital investors were willing to buy shares in unproven and/or unprofitable models, because the future seemed so fantastic. There is still a "bar" that must be passed, which is one of credibility. However, credibility can be gained by a compelling business idea, known venture capitalists, and known management.
The Company Hires an Investment Banker
To offer public shares the company hires an investment banker, or several bankers, as underwriters.
Investment bankers offer a simple service. They guarantee to the company that they will purchase all the shares the company offers on the day of the offering for the IPO price, minus the firm's commission.
Generally, the commission is between 5 and 7% of the amount raised. The investment banker is paid on a percentage basis, because it risks its own capital to buy all the shares.
Filing the S-1
The next step is that the company files an S-1 registration with the SEC, which is called the prospectus.
This form is a must-read if you decide you want to own the IPO stock for the long term. It is less important if all you want to do is flip the stock on the IPO day. But it is always wise to know as much as you can about the company.
Do not confuse the shares issued for sale with the total shares outstanding. Frequently, in reports of a new IPO the shares to be sold are listed as "Total shares." We have had some questions of confusion over this issue in the past, so make sure you know both the total shares offered and the total shares outstanding. Typically, in an IPO about 10-15% of the company is offered for sale.
The Investment Banker Sells the Deal
Investment bankers guarantee to the company that they will purchase all the shares.
But they intend to sell them, or at least the bulk of them, immediately to their institutional clients. Those clients must be "sold" first.
To do this, they take the CEO, and usually the CFO, of the company on a "road show" to institutions across the country. The road show gives institutions a quick presentation on the company's plans and the opportunity to ask questions of the CEO.
If convinced, the institutions "subscribe" to the offering, which is a non-binding commitment to purchase shares on the day of the IPO. Since the price is not determined until the last minute, institutions put in a subscription request for a certain number of shares, but the exact cost is unknown. They are not obligated to take any or all the shares if they so choose.
Investment bankers gauge the demand, and set a price as high as they can, balanced by trying to ensure that everyone will buy it.
Institutions are no different than anyone else. Some will argue the price. Others will just place an order.
Some will buy the IPO shares for long-term holding. Others will flip them as soon as possible. The investment bankers, who will be market makers in the stock, prefer to have friendly hands holding the stock for as long as possible. Instant flipping is not always looked upon favorably, but anytime you make money for a client, you have a happy client.
The Deal Closes
Prior to the IPO, investment bankers do their best to confirm all their client orders. If demand is high, the price may rise, at which time all the clients are called again, and subscriptions readjusted.
On the day of the IPO, when the investment banker is certain of selling all the shares, the deal closes. The shares, all of them, are purchased from the company by the investment bankers. The price paid is the IPO price minus the commission.
The bankers then sell all the subscribed shares to the institutions at the same time for the IPO price. If any client withdraws their bid, the bankers own the shares and either hold them, or sell them to someone else. On hot IPOs this doesn't happen much, but it does happen.
Note that the transaction between the client subscribers and the investment bankers always happens in accounts at the investment bank. A credit for the shares is placed into the client's account, and a debit for the cash is made, all at the same time. None of the clients get a "head start" on any of the others.
Shares Start Trading
The shares are "released" for trading when the investment bankers have made this credit in the client accounts.
At that point, any client who wants to can start selling.
Of course, the only market makers for the stock in the beginning are the underwriters.
So, if someone outside the institutional-investment bank relationship wants to buy shares, the only person they can buy them from are either clients of the underwriters, or the underwriter itself, as the market maker.
What Determines the First Trade Price?
Just like anything else in the stock market, the price is determined by bids.
Those bids are placed, just like any other bid, through a broker, who routes the bid to the market maker.
The stock market is an auction. When the guy next to you is willing to pay $50 and you aren't, you don't get the stock. And if the guy next to you says, "I'll pay more than whatever that guy is paying" (translate = market order), you don't get the stock.
The problem with IPOs is that there isn't any previous price for the stock. The IPO price is irrelevant. It represents demand among the institutional clients.
The first trade represents demand in the public market. Since the underwriter is also the market maker, (for Nasdaq stocks) they know exactly how many shares its institutional clients want to sell. They may even counsel clients to control the available supply.
But demand is completely generated from the outside. If there weren't market orders placed for IPO stock, there would never be IPOs that double or triple on the first trade.
No Trades in the Gap
So, the first trade goes out to the market orders. The price they pay is a "reasonable" amount higher than the limit orders in the queue. What the price winds up being is anyone's guess.
But it is important to understand - there were no trades in the gap.
When Briefing.com reports that an IPO has opened at $60, when the IPO price was $15, there weren't any trades at $30 or $40. The price just jumped, just like it does for non-IPO stocks overnight on news.
You haven't missed out on a $45 opportunity when you see that an IPO has risen from $15 to $60 on its first trade. The opportunity was never there.
