Initial public offerings

An initial public offering (IPO) is the process by which a private company transforms itself into a public company. The company offers, for the first time, shares of its equity (ownership) to the investing public. These shares subsequently trade on a public stock exchange like the New York Stock Exchange (NYSE) or the Nasdaq.

The first question you may ask is why a company would want to go public. Many private companies succeed remarkably well as privately owned enterprises. One privately held company, Cargill, tops $50 billion in revenue each year. And until 1999, Wall Street's leading investment bank, Goldman Sachs, was a private company. However, for many large or growing private companies, a day of reckoning comes for the owners when they decide to sell a portion of their ownership in their firm to the public.

The primary reason for going through the rigors of an IPO is to raise cash to fund the growth of a company and to increase the company's ability to make acquisitions using stock. For example, industry observers believe that Goldman Sachs' partners wished to at least have available a publicly traded currency (the stock in the company) with which to acquire other financial services firms.

While obtaining growth capital is the main reason for going public, it is not the only reason. Often, the owners of a company may simply wish to cash out either partially or entirely by selling their ownership in the firm in the offering. Thus, the owners will sell shares in the IPO and get cash for their equity in the firm. Or, sometimes a company's CEO may own a majority or all of the equity, and will offer a few shares in an IPO in order to diversify his/her net worth or to gain some liquidity. To return to the example of Goldman Sachs, some felt that another driving force behind the partners' decision to go public was the feeling that financial markets were at their peak, and that they could get a good price for their equity in their firm. It should be noted that going public is not a slam dunk. Firms that are too small, too stagnant or have poor growth prospects will - in general - fail to find an investment bank (or at least a top-tier investment bank, known as a "bulge bracket" firm) willing to underwrite their IPOs.

From an investment banking perspective, the IPO process consists of these three major phases: hiring the mangers, due diligence, and marketing.

Hiring the Managers. The first step for a company wishing to go public is to hire managers for its offering. This choosing of an investment bank is often referred to as a "beauty contest." Typically, this process involves meeting with and interviewing investment bankers from different firms, discussing the firm's reasons for going public, and ultimately nailing down a valuation. In making a valuation, I-bankers, through a mix of art and science, pitch to the company wishing to go public what they believe the firm is worth, and therefore how much stock it can realistically sell. Perhaps understandably, companies often choose the bank that predict the highest valuation during this beauty contest phase instead of the best-qualified manager. Almost all IPO candidates select two or more investment banks to manage the IPO process. The primary manager is known as the "lead manager,"while additional banks are known as "co-managers."

Due Diligence and Drafting. Once managers are selected, the second phase of the IPO process begins. For investment bankers on the deal, this phase involves understanding the company's business as well as possible scenarios (called due diligence), and then filing the legal documents as required by the SEC. The SEC legal form used by a company issuing new public securities is called the S-1 (or prospectus) and requires quite a bit of effort to draft. Lawyers, accountants, I-bankers, and of course company management must all toil for countless hours to complete the S-1 in a timely manner. The final step of filing the completed S-1 usually culminates at "the printer" (see sidebar in Chapter 8).

Marketing. The third phase of an IPO is the marketing phase. Once the SEC has approved the prospectus, the company embarks on a roadshow to sell the deal. A roadshow involves flying the company's management coast to coast (and often to Europe) to visit institutional investors potentially interested in buying shares in the offering. Typical roadshows last from two to three weeks, and involve meeting literally hundreds of investors, who listen to the company's canned PowerPoint presentation, and then ask scrutinizing questions. Insiders say money managers decide whether or not to invest thousands of dollars in a company within just a few minutes into a presentation.

The marketing phase ends abruptly with the placement and final "pricing" of the stock, which results in a new security trading in the market. Investment banks earn fees by taking a percentage commision (called the "underwriting discount," usually around 8 percent for an IPO) on the proceeds of the offering. Successful IPOs will trade up on their first day (increase in share price). Young public companies that miss their numbers are dealt with harshly by institutional investors, who not only sell the stock, causing it to drop precipitously, but also quickly lose confidence in the management team.

Follow-on offering of stock

A company that is already publicly traded will sometimes sell stock to the public again. This type of offering is called a follow-on offering, or a secondary offering. One reason for a follow-on offering is the same as a major reason for the initial offering: a company may be growing rapidly, either by making acquisitions or by internal growth, and may simply require additional capital.

Another reason that a company would issue a follow-on offering is similar to the cashing out scenario in the IPO. In a secondary offering, a large existing shareholder (usually the largest shareholder, say, the CEO or founder) may wish to sell a large block of stock in one fell swoop. The reason for this is that this must be done through an additional offering (rather than through a simple sale on the stock market through a broker), is that a company may have shareholders with "unregistered" stock who wish to sell large blocks of their shares. By SEC decree, all stock must first be registered by filing an S-1 or similar document before it can trade on a public stock exchange. Thus, pre-IPO shareholders who do not sell shares in the initial offering hold what is called unregistered stock, and are restricted from selling large blocks unless the company registers them. (The equity owners who hold the shares sold in an offering, whether it be an IPO or a follow-on, are called the selling shareholders.)

The Process.

The follow-on offering process differs little from that of an IPO, and actually is far less complicated. Since underwriters have already represented the company in an IPO, a company often chooses the same managers, thus making the hiring the manager or beauty contest phase much simpler. Also, no real valuation work is required (the market now values the firm's stock), a prospectus has already been written, and a roadshow presentation already prepared. Modifications to the prospectus and the roadshow demand the most time in a follow-on offering, but still can usually be completed with a fraction of the effort required for an initial offering.

Bond offerings

When a company requires capital, it sometimes chooses to issue public debt instead of equity. Almost always, however, a firm undergoing a public bond deal will already have stock trading in the market. (It is relatively rare for a private company to issue bonds before its IPO.)

The reasons for issuing bonds rather than stock are various. Perhaps the stock price of the issuer is down, and thus a bond issue is a better alternative. Or perhaps the firm does not wish to dilute its existing shareholders by issuing more equity. Or perhaps a company is quite profitable and wants the tax deduction from paying bond interest, while issuing stock offers no tax deduction. These are all valid reasons for issuing bonds rather than equity. Sometimes in down markets, investor appetite for public offerings dwindles to the point where an equity deal just could not get done (investors would not buy the issue).

The bond offering process resembles the IPO process. The primary difference lies in: (1) the focus of the prospectus (a prospectus for a bond offering will emphasize the company's stability and steady cash flow, whereas a stock prospectus will usually play up the company's growth and expansion opportunities), and (2) the importance of the bond's credit rating (the company will want to obtain a favorable credit rating from a debt rating agency like S&P or Moody's, with the help of the "credit department" of the investment bank issuing the bond; the bank's credit department will negotiate with the rating agencies to obtain the best possible rating). As covered in Chapter 5, the better the credit rating - and therefore, the safer the bonds - the lower the interest rate the company must pay on the bonds to entice investors to buy the issue. Clearly, a firm issuing debt will want to have the highest possible bond rating, and hence pay a lower interest rate (or yield).

As with stock offerings, investment banks earn underwriting fees on bond offerings in the form of an underwriting discount on the proceeds of the offering. The percentage fee for bond underwriting tends to be lower than for stock underwriting. For more detail on your role as an investment banker in stock and bond offerings, see Chapter 8.