Tuesday, May 8, 2012

What is an IPO?

Everything you need to know about IPOs

An initial public offering (IPO) is referred to a situation when a small company goes to the stock exchange, to get itself listed for the “first time”, and “offers” its shares to the “public”. This is primarily done by (relatively) small companies who are wishing to grow and compete with their industry giants.
To expand, a business needs cash (capital) and cash can come either if the company

a)      Borrows money i.e. through debt (Not IPO)

A company can borrow money by issuing debts. The debt holders are the creditors of the company and earn interest on debts.

b)      Issues shares i.e. through equity (IPO)

Alternatively a company can issue shares. Shareholders then become the owners of the company and receive dividends. IPO happens when the company raises equity by issuing shares for the first time through any stock exchange anywhere in the world.

Private to Public

Usually a business is first registered as a private company before it goes public, e.g. Google, Visa, etc. A private company has fewer shareholders and shares are privately traded. General public doesn’t have any information about the financials of private company, they do not know who the shareholders are, what their income is, how many assets have they got, etc. Nothing is disclosed, although several financial analysts make estimates about their financial condition.

For example, we didn’t know anything about facebook’s internal financial info until the company planned for an IPO and revealed their previous year’s performance.  Many financial analysts had thought that Mr. Zuckerberg owns around 7-10% of the company, we now know that he actually owns 28.4% of the business and has more than 50% voting rights.

The public companies, on the other hand, are traded on the stock exchange, and anyone can buy and sell their shares. Public companies have to reveal all of their financial reports, at least each year, to the general public. They must have a board of directors, who are responsible for running the company and represent the shareholders. All public companies in U.S. must report to the Securities and Exchange Commission.

Biggest advantage of Public Company

Perhaps the biggest advantage of a public company is the ease with which they can raise capital. If they wish to increase their equity base, then they can issue shares. If not, they can issue debentures and borrow money, or they can go to banks directly for financial needs. Banks usually lend money to all public listed companies at the lowest rates. In fact, there is an interest rate on short term loans called “Prime Rate” which is offered only to public limited companies with outstanding track record.

Advantage of IPO

Since anyone can buy the shares of a public company, so naturally they attract a large number of potential investors (depending on their past performance!). Usually companies with a powerful brand image emerge extremely successful from an IPO.

Many individuals use IPO as their “exit strategy”. If you are a major shareholder of a successful private company for an IPO then you can sell your own shares at a much higher price (which can potentially make you a millionaire overnight). You can either
a)      retain some of your shares, sit back and earn dividends and let the CEO and board of directors do all the work
b)      retain your shares, join the board of directors, your share values would have multiplied many folds PLUS you can get an incredible compensation package as well
c)      You can sell all of your shares and retire.