How an IPO Works

A Corporate Finance department's most prominent function is the raising of capital for clients, sometimes through IPOs (Initial Public Offerings), the process of taking a company public. To do this, investment bankers determine the client's financial requirements, whether the company should raise the money by issuing equity (stock) or debt (bonds), or a combination of both, and how to price these securities. After researching the financial background of the company (a process called due diligence) to uncover risks and to assuage any potential concerns the Securities and Exchange Commission may have (the agency must approve any large securities offering), the investment bank usually prepares documents (called a prospectus) that detail the company's business, historical performance, and the terms of the securities offered. As soon as the SEC rubber stamps the prospectus, the investment bank sells the securities to the public.

Investment banks underwrite stock and bond offerings. That is, they purchase either a portion of, or the entire issue, in order to ensure that the cash the client needs will be raised. The bank then immediately sells the securities to clients at a slightly higher price (the difference is called the spread). It is the bank's goal to accurately price an offering, or perhaps to price it at a little bit below its true market value. Say an investment bank has convinced a company that it should go public by issuing one million shares at $30 a share. After the shares hit the market, they balloon to $40 a share. The company is somewhat disappointed because it could have generated an additional $10 million more from the public (one million shares x $50). The bank's clients are pleased because they bought a stock at well under market value. The rationale for this under-pricing? If the bank values the company at just under its market value, its clients will receive a nice immediate boost, and the company has generated good buzz for its shares because the offering is viewed as successful.