Who Determines the Initial Public Offering Price?
Public companies go public for two reasons: to raise capital or to extract value for existing shareholders, which means profit for those who hold shares before the initial public offering (IPO). Successful companies in their market that build brand awareness then use the proceeds to make capital investments and acquisitions to drive growth and profitability. Current shareholders can sell some or all of their shares to a ready market.
When companies consider going public, they typically hire an investment bank to provide advice and guide them through the lengthy and costly process.
Investment banks play another important role in the IPO process: underwriting. What happens during the underwriting process is that the investment bank – in this case acting as the underwriter – purchases some or all of the shares of the IPO to guarantee its success.
There are several methods that investment banks follow in pricing, depending on the type of deal struck with the company that intends to go public.
Firm Commitment
Initial public offerings are often firm commitment deals where the investment bank agrees to purchase all the initial shares from the company (the issuer) at an agreed-upon price.
The final price of the offering is determined by the investment banks based on their estimates of what the market will pay for the company’s shares.
Since banks are committed to buying all the shares, they want to ensure that investors will fully participate in the offering. Banks are compensated by the company at a percentage of the total proceeds, known as the spread. The average spread for initial public offerings between 1980 and 2020 was about 5.5% of total proceeds.
Best Efforts
Under a best efforts agreement, the investment bank agrees to sell as many shares as possible. Unlike a firm commitment, the underwriter has the option, not the obligation, to buy shares from the company and has the authority to sell them to investors. Banks must sell a minimum number of shares; otherwise, the offering will be canceled, and the company does not pay any fees.
Auction
A public auction process is used to determine the offering price. All interested investors are given the opportunity to bid on the shares before the initial public offering. This process limits the role of investment banks, making the auction IPO fees generally lower than a firm commitment or best efforts. The most famous auction IPO was Google’s in 2004. Although there were 28 underwriters in this offering, the underwriting fees were about half the fees of other IPOs because buyers were found through the auction process.
Direct Listing
Shares are offered directly to investors by the company on the first trading day. In a direct listing, the share price is determined based on supply and demand in the market. Underwriters do not participate in the sale. The cryptocurrency exchange platform Coinbase used a direct listing in April 2021.
Initial Public Offering Pricing Process
There are several steps involved in the traditional process of determining the initial public offering price where investment banks decide on the IPO price.
Initial Pricing
The pricing process starts with a thorough analysis of the company to prepare the registration statement for the Securities and Exchange Commission (SEC). The first part of the registration statement is the prospectus, which contains the information investors need about the business, the offering, and management. The second part contains additional information for the SEC about the offering, such as expenses and fees.
There are many teams involved in the process. The legal team for the issuer, for example, prepares the statement and communicates with the SEC. The accounting team prepares the financial statements for the issuer and reviews them to ensure they have been properly included. The investment bank team researches the financial data, market position of the issuer, company strategy, and comparable companies. Models are created to forecast the impact of additional capital funding on the size, scope, and profitability of the business.
Enhancement
The Offering
Once the registration statement is filed, the investment bank team begins building the book. Book building is a process of marketing the offering to the market and gathering non-binding bids for the shares. This is a significant part of a successful offering as it provides feedback from the market regarding the share price.
The book building starts with a series of promotional rounds that help to market the offering and generate excitement. The rounds can include phone calls with multiple investors, in-person meetings, and disseminating materials online about the issuer’s business and the offering. There are Q&A sessions in each round that give investors insight into the management’s strategy and the company’s future potential. However, the most important rounds are the face-to-face meetings with the investment bank’s network of institutional and major investors. These face-to-face meetings give key investors the opportunity to interact directly with the CEO, CFO, and other senior management.
During the offering rounds, the investment bank will solicit indications of interest. Potential investors submit non-binding offers for the number of shares they wish to acquire and the price they are willing to bid. Indications of interest are a crucial part of price discovery for the offering.
Final Offering Price
The investment bank uses the indications of interest and the response from the offering rounds to set the final offering price. The legal team submits a request to the Securities and Exchange Commission (SEC) to set a registration effective date, and then the board approves the offering price. Once the SEC deems the registration effective, shares are allocated to investors at the final offering price. Trading on the exchange begins on the listing day.
Offering Price vs Opening Price
The offering price determines the amount of money paid to the issuer for the shares, while the opening price on the exchange reflects what the broader market is willing to pay for the shares. The investment bank team must balance the two most important yet opposing roles: in representing the issuer, they have an obligation to get the highest possible price for the shares for the offering. At the same time, they want to make the price attractive enough to encourage investors to buy all the shares.
Why It Matters to Individual Investors?
Sometimes, investment banks allocate shares to brokerage firms with retail clients. If your brokerage agent has an allocation, they might only offer it to clients with large accounts. For most investors, access to IPO shares is extremely limited. However, all investors can purchase shares once trading begins.
Buying shares right after the IPO can be risky as prices can be volatile. In the first few days following the trading start, according to the SEC, the investment bank may support the price by buying shares. After the support ends, the price may significantly decline below the offering price.
Stock prices can also rise sharply due to the limited supply of shares available in the market after the IPO. Current shareholders’ shares may not be available for six months due to “lock-up” restrictions. Investment banks also limit supply by restricting speculation. Speculation is selling IPO shares in the market immediately. Investment banks discourage allocations to clients who have sold IPO shares in the past.
Another way to invest is to buy an Exchange-Traded Fund (ETF) of the IPO. IPO ETFs, such as First Trust US Equity Opportunities ETF (FPX), track the IPOX-100 Index (market-cap-weighted portfolio) and invest in companies that have recently gone public. The advantage of using an ETF is that it allows investment in multiple IPO companies for a relatively small amount.
Finally,
As of December 2020, companies can utilize direct listing to raise capital by issuing new shares. Direct listing may provide more initial public offering opportunities for small investors in the future. The decision to invest in initial public offering companies, like all other investments, should be based on your financial goals, time frame, and risk tolerance.
Source: https://www.thebalancemoney.com/how-are-initial-public-offerings-ipos-priced-5181351
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