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How the IPO Process Works: A Foolish Brief

By Eric Volkman - Sep 8, 2015 at 7:00PM

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Investors are fascinated by initial public offerings; here's how they're conceived and born.

So you want to launch your company on a stock exchange, eh? Good idea. The equity market is arguably the best source of funding for an enterprise that needs lots of capital, and can't (or doesn't want to) wait a long time to get it.

Source: Luis Villa del Campo, via Wikipedia

Companies come to market via an initial public offering, known by its three famous initials, IPO. We've dived into the basics of this type of fund sourcing in our article "What is an IPO? A Fool Explains." In this brief, we'll cover the major stages of a new stock issue arriving on the bourse, taking a peek behind the curtain at how the process actually goes down.

On the road to an IPO
The first, and probably most important, part of the operation is for a prospect company to solicit an underwriting syndicate. An "underwriter," in this case, is a financial services company (typically an investment bank) that will sell the freshly minted shares to investors.

Most underwriters don't want to take on a decently sized IPO on their own, as doing so can be risky. That's why one or several peers are usually drafted to help with the issue. A group of underwriters is called a "syndicate," and can get pretty formidable depending on the issuing company and the size of the IPO.

For example, it took six heavyweight investment banks -- among them Goldman Sachs and Morgan Stanley -- to underwrite Facebook's massive 2012 IPO.

Then the fun starts. At investor "road shows," the issuing company is put on display in an attempt to convince big institutional investors to buy large blocks of shares. After all these potential buyers -- funds, peer investment banks, and other deep-pocketed entities -- are the ones with the scope and resources to take on such stakes.

Road shows are basically intended to determine the pricing of the IPO. Based on the reaction and feedback generated by these pieces of financial theater, a final per-share figure for the stock is fixed. Aha, so now we have a market price!

Price spread
Actually, no. This is a source of confusion to many people who track the progress of an IPO. The quoted amount is what the institutional investors will pay for their shares. They're the buyers we read about when the headlines blare news like "BirdsColoredGreen.com IPO Raises $250 Million at $20 Per Share."

The following day, it's those institutional investors that sell all/some/a few of their shares via the exchange, not the underwriters. This is why the stock market price is often wildly different than that of the IPO; it basically depends on the bids of a vast pool of potential buyers, rather than the limited number of institutionals that first absorbed the issuer's shares.

One recent example of this price disparity is the IPO of popular burger joint Shake Shack. The company's stock was sold for $21 per share in the institutional phase of the issue.

The following day, thanks to swollen demand from the general market, it opened much higher, at $47.21. The stock traded around that price for the remainder of the day, finally dipping a bit to close at $45.90.

Of course, once the shares hit the market, the issuer is officially a publicly traded company. The final step in the process is to comply with the many rules and regulations stipulated by the forest of U.S. capital markets law, and the specific exchange on which the new stock is listed. This, of course, lasts as long as the stock remains on the bourse.

Source: pingnews.com, via Flickr

These requirements include, but are nowhere near limited to, releasing detailed, audited financial statements on a quarterly basis, maintaining minimum levels of equity, having a certain number of market makers in the stock, etc. etc. etc.

Stock, exchanged
Going public can be a long, grueling process fraught with uncertainty. It's fortunate, then, that there are many companies involved in bringing new stocks to market. So a business with potential has a fine chance to get all the help it needs to make its listing.

The capital is out there, and in a nutshell, this is how the stock market's companies go about getting it. New enterprises are constantly landing on the exchanges for that reason. Will your business be next?

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