IPO (Initial Public Offerings)

(Notes by "Ozzie Dilbert", 1999)


In my investing I had not had any reason to look at IPOs until this year, when FIBR (in which I hold a stock position as well as an emotional attachment) decided to spin out its NetSilicon division, now trading as NSIL.

While following this process, I learned a lot about the IPO process, and seeing how much mis-information is spread around on the bulletin boards, I decided to share some of it.

Why Go Public?

Companies make initial public offerings for a variety of reasons, and understanding the reason for a particular offering will help set realistic expectations for how successful it will be. Here are some reasons for IPOs:

The Role of the Underwriter

Every public offering must be managed by an underwriter. Usually, two brokerage houses are sharing this role, so that there is a lead underwriter and a co-manager.

The underwriter acts as the company's agent on Wall Street. The underwriter and the company agree on a number of shares and a price per share, and the underwriter basically buys all the new stock at the agreed price and sells it into the market. Generally, the an estimated price range is determined a couple of months ahead of time; the final price is set the day before trading begins. At the time of pricing, the deal can still be scuttled by either the company or the underwriter. Once the pricing is committed, the underwriter carries the risk if the price is too high.

The Stages of an IPO

There are many steps to an IPO. Here I will focus on the financial transactions happening in the brief period just before and after the first trading days.
  1. Announcement of Intent
    Generally, the intent to make a public offering will be announced prior to making an SEC filing.
  2. Selecting an Underwriter
    It is desirable to have a well-respected firm as the underwriter. An underwriter's reputation depends on their track record of prior IPOs in the particular industry sector.
  3. Prospectus
    A formal prospectus must be written and filed with the SEC (Form 1). This will outline all the material facts about the company, and if the facts change, a revision must be filed (Form 1/A - A for Amended).
  4. Road Show
    With the prospectus in hand, a representative of the underwriter travels with company management to give presentations to people in the brokerage industry to persuade them that this new stock is a good investment opportunity, and to persuade them to take an allocation of the new stock.
  5. Allocations
    The newly created stock is sold by the company to the underwriter at an agreed-upon fixed price. The underwriter usually allocates a significant fraction of the stock to other brokerages, who can either sell it for the house account, or - more commonly - offer it to their best clients at the fixed price. This opportunity to take IPO stock at the issue price and sell it on the same day is one of the few guaranteed ways to make money legally. The underwriter's own employees are not allowed to take allocations, but they can give them to their friends at other brokerages, who will then return the favor next time they manage an IPO.
    After the road show and allocation negotiations, it will be fairly clear if the brokerage houses in general agree with the proposed price range.
  6. Pricing
    The evening before the offering, the company management and the underwriter's group will meet to finalize the price ... or kill (postpone) the deal "due to unfavorable market conditions". They have to set the price below their assessment of a realistic long-term price, in order to make sure that the underwriter won't lose money as they unload their allocation during the quiet period.
  7. First Day
    Before the open, the new stock symbol will have been loaded on the NASDAQ computers, and brokerages will have posted bids on behalf of investors who do not have allocations, but have faith in the new stock. Around 11 AM, the first offers to sell will be posted, and for the next hour, trading will be frantic as the stock struggles to find its price.
    At this time, the underwriters and the partners with allocations will typically offer a trickle of shares at twice the issue price. If there is a lot of demand, they will then keep raising the price, if not, they will drift downwards until the demand appears. Usually, the volume during this hour adds up to between a third and half of the offered stock. A stock with a lot of hype and great public interest may continue to float up during the day; it may close at three times the issue price and keep rising for the next week or two. Note, that this represents a situation where the underwriter is taking a huge profit that rightfully should have gone to the company via a higher issue price.
    More commonly, if the price was set right, the stock will close the first day 40%-60% above the issue price.
  8. Unloading by Underwriter
    Over the next week or two, the underwriter will slowly release the stock offering into the market at a controlled rate. During this period, the stock will often drift lower until the underwriter finishes unloading and the market stabilizes. For most investors, this is the best time to buy into the new stock.
  9. Quiet Period
    In order to ensure a level playing field, the SEC insists that the prospectus (as filed with the SEC) is the only information from the brokerage houses to potential investors. This restriction is relaxed after about 3 weeks. This period is known as "the quiet period".
  10. Regular Coverage
    After the quiet period ends, analysts at the brokerage houses can start recommending the stock in their newsletters etc. This generally will lead to upward movement.

An Example of an IPO: NSIL