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The Initial Public Offering

Very few new businesses make it big, but those that do can be very profitable. For example, an investor who provided $1,000 of first-stage financing for Intel would by mid- 2000 have reaped $43 million. So venture capitalists keep sane by reminding themselves of the success stories1 ¤those who got in on the ground floor of firms like Intel and Federal Express and Lotus Development Corporation.2 If a startup is successful, the firm may need to raise a considerable amount of capital to gear up its production capacity. At this point, it needs more capital than can comfortably be provided by a small number of individuals or venture capitalists. The firm decides to sell shares to the public to raise the necessary funds.

A firm is said to go public when it sells its first issue of shares in a general offering to investors. This first sale of stock is called an initial public offering, or IPO.

An IPO is called a primary offering when new shares are sold to raise additional cashfor the company. It is a secondary offering when the company`s founders and the venture capitalist cash in on some of their gains by selling shares. A secondary offer therefore is no more than a sale of shares from the early investors in the firm to new investors, and the cash raised in a secondary offer does not flow to the company. Of course, IPOs can be and commonly are both primary and secondary: the firm raises new cash at the same time that some of the already-existing shares in the firm are sold to the public. Some of the biggest secondary offerings have involved governments selling off stock in nationalized enterprises. For example, the Japanese government raised $12.6 billion by selling its stock in Nippon Telegraph and Telephone and the British government took in $9 billion from its sale of British Gas. The world`s largest IPO took place in 1999 when the Italian government raised $19.3 billion from the sale of shares in the state-owned electricity company, Enel.

ARRANGING A PUBLIC ISSUE

Once a firm decides to go public, the first task is to select the underwriters

Underwriters are investment banking firms that act as financial midwives to a new issue. Usually they play a triple role ¤first providing the company with procedural and financial advice, then buying the stock, and finally reselling it to the public.

A small IPO may have only one underwriter, but larger issues usually require a syndicate of underwriters who buy the issue and resell it. For example, the initial public offering by Microsoft involved a total of 114 underwriters.

In the typical underwriting arrangement, called a firm commitment, the underwriters buy the securities from the firm and then resell them to the public. The underwriters receive payment in the form of a spread ¤that is, they are allowed to sell the shares at a slightly higher price than they paid for them. But the underwriters also accept the risk that they won`t be able to sell the stock at the agreed offering price. If that happens, they will be stuck with unsold shares and must get the best price they can for them. In the more risky cases, the underwriter may not be willing to enter into a firm commitment and handles the issue on a best efforts basis. In this case the underwriter agrees to sell as much of the issue as possible but does not guarantee the sale of the entire issue.

Before any stock can be sold to the public, the company must register the stock with the Securities and Exchange Commission (SEC). This involves preparation of a detailed and sometimes cumbersome registration statement, which contains information about the proposed financing and the firm`s history, existing business, and plans for the future.

The SEC does not evaluate the wisdom of an investment in the firm but it does check the registration statement for accuracy and completeness. The firm must also comply with the ¬blue-sky ­ laws of each state, so named because they seek to protect the public against firms that fraudulently promise the blue sky to investors.3

The first part of the registration statement is distributed to the public in the form of a preliminary prospectus. One function of the prospectus is to warn investors about the risks involved in any investment in the firm. Some investors have joked that if they read prospectuses carefully, they would never dare buy any new issue. The appendix to this material is a possible prospectus for your fast-food business.

The company and its underwriters also need to set the issue price. To gauge how much the stock is worth, they may undertake discounted cash-flow calculations like those described earlier. They also look at the price-earnings ratios of the shares of the firm`s principal competitors.

Before settling on the issue price, the underwriters may arrange a ¬roadshow, ­ which gives the underwriters and the company`s management an opportunity to talk to potential investors. These investors may then offer their reaction to the issue, suggest what they think is a fair price, and indicate how much stock they would be prepared to buy.This allows the underwriters to build up a book of likely orders. Although investors arenot bound by their indications, they know that if they want to remain in the underwriters` good books, they must be careful not to renege on their expressions of interest.

The managers of the firm are eager to secure the highest possible price for their stock, but the underwriters are likely to be cautious because they will be left with any unsold stock if they overestimate investor demand. As a result, underwriters typically try to underprice the initial public offering. Underpricing, they argue, is needed to tempt investors to buy stock and to reduce the cost of marketing the issue to customers. It is common to see the stock price increase substantially from the issue price in the days following an issue. Such immediate price jumps indicate the amount by which the shares were underpriced compared to what investors were willing to pay for them. A study by Ibbotson, Sindelar, and Ritter of approximately 9,000 new issues from 1960 to1987 found average underpricing of 16 percent.4 Sometimes new issues are dramatically underpriced. In November 1998, for example, 3.1 million shares in theglobe.com were sold in an IPO at a price of $9 a share. In the first day of trading 15.6 million shares changed hands and the price at one point touched $97. Unfortunately, the bonanza did not last. Within a year the stock price had fallen by over two-thirds from its first-day peak. The nearby box reports on the phenomenal performance of Internet IPOs in the late 1990s.

Underpricing represents a cost to the existing owners since the new investors are allowed to buy shares in the firm at a favorable price. The cost of underpricing may be very large.

PROSPECTUS Formal summary that provides information on an issue of securities.

UNDERPRICING Issuing securities at an offering price set below the true value of the security.

UNDERWRITER Firm that buys an issue of securities from a company and resells it to the public.

SPREAD Difference between public offer price and price paid by underwriter.

INITIAL PUBLIC OFFERING (IPO) First offering of stock to the general publi