The Process Of An Initial Public Offering (Ipo). The Underpricing Problem.
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1. Introduction
All companies need to raise capital at one time or another, first of all to start-up their business, and then to finance new projects and expand operations. Most of them start out by raising money from private sources, with no liquid market existing if the investors wish to sell their stock. A lot of new ventures rely initially on these internal funds, which come mostly from relatives and friends; some other firms, instead, receive help from the so-called “angel investors”. Furthermore, in some countries as Italy, debt (bank loans) is the main form of financing. Indeed, even after the start-up, there are many successful entrepreneurs (e.g. IKEA, Domino’s Pizza and Levi Strauss) who continue to operate successfully as private, unlisted companies.

Anyway, if a company prospered, it would need additional equitiy capital. To raise it, a firm usually “go public”; it means that it starts selling a portion of itself to a large number of diversified investors. What occurs in this case is named IPO (Initial Public Offering): a security is sold to the general public for the first time, and thanks to this, usually, a liquid market will develop.

The process is long and subject to strict rules and regulations. My purpose is that of going through the main steps of it, analysing pros and cons of IPOs and providing explanations for their apparent “underpricing”. I will mainly concentrate on the U.S. model, but being aware that other systems, like the European ones, might be slightly different.

2. The IPO process
An IPO works thanks to a process known as “underwriting”.
Even if in theory is possible for a company to sell shares on its own (from the mid-1990s, a growing number of small companies have followed the way of direct public offerings — DPOs), realistically, an investment bank is required. So, the first task for a firm is that of hiring an underwriter, with the role of middleman between the company and the investing public. Some of the most famous underwriters all over the world are Goldman Sachs, Merrill Lynch, Lehman Brothers and Morgan Stanley.

Investment banks have three functions: giving procedural and financial advice to the firm, buying the issue, and reselling it to the final investors.
Once selected the “sponsor”, the company formally apply to be admitted to the primary market. In the United States, it will be asked by the Securities and Exchange Commission (SEC) to fully disclose information related to proposed financing, firm’s past and present, future plans, legal problems and insider holdings. The document that it will prepare to obtain SEC clearance is called “registration statement”. The U.K. system works more or less in the same way, with the UKLA (UK Listing Authority) overseeing the quotation process and looking at rules to be respected. In both systems few attempts are made to determine whether a security is fairly priced or not (e.g. “blue sky laws” and Office for Fair Trading — OFT): this to facilitate the raise of capital and the development of a liquid market.

During the “cooling off period”, in which SEC investigate the observance of the requisites, the underwriter select the most important parts of the statement and put them together into a preliminary prospectus (also known as “red harring”), which is then distributed to the public. IPO marketing activity starts now: the company (helped by the sponsor), with the prospectus in hand, arrange a “road show” to major cities and, in case of largest offerings, to other big markets such as London or Asian ones. The goal of this operation is to hype and build up interest for the issue, and to do that big institutional investors are courted during this campaign. Offer price and effective offering date are still not known by that moment, but, thanks to registered reactions, the underwriter is able to get an idea about the amount of stock the public would likely buy, and how much is it probably prepared to pay for it.

As soon as clearance from SEC is received, the issuer and the underwriter sit down and decide on the price and the stock amount. This is a complex decision, deeply influenced by the company, the success of marketing researches, current market conditions and, last but not least, the contractual form which connect the firm and the investment bank. With a best efforts contract, a price and a range of shares to be sold are fixed before collecting information about the state of demand; then, there is a period, usually 90 days, in which the underwriter must make its “best efforts” to sell the shares to the public (if the minimum stock is not sold, the offer is withdrawn and investors refunded).

When a firm commitment contract is signed, instead, the investment bank usually adopt the book-building method: it constructs a demand curve, thanks to the information collected during the road show. As a consequence, it is possible to decide on the stock amount and the offer price in a more accurate way; this can be translated in a sensible reduction of unallocated shares, a risk which none of the banks under this kind of contract wants to run (in fact, they guarantee to raise a certain amount by buying the whole offer first, and then reselling to the investors!). The number of companies using this method is growing throughout the world, even in the U.K. where is nevertheless more used the “fixed price offer” method.

At this time, there is just one thing left to do: starting selling the securities on the stock market and collecting money from investors.
As we can see, pricing is probably the longest and most expensive moment of the IPO process, involving concrete costs (e.g. marketing activity) and intangible, psychological costs due to the high stress of whole months spent following market and environment changes, and trying to adapt one’s decisions to that. Moreover, this is actually the part of the process which breeds the “underpricing” matter: I’m going to explain how, immediately after a brief reflection upon costs and benefits of IPOs.

3. “Pro and cons” of IPOs
IPO is a decisive turning point in firms’ lives and, as all changes, brings of course either good or bad consequences. I think we can distinguish the effects of IPOs sorting them by the main subjects involved — issuing companies

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Process Of An Initial Public Offering And Bank Loans. (July 6, 2021). Retrieved from https://www.freeessays.education/process-of-an-initial-public-offering-and-bank-loans-essay/