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Personal Finance: Anatomy of an IPO

This year has been a decent year for new stock issues, with about 120 companies going public and raising around $40 billion in new capital so far in 2019. However, some cracks are appearing in the IPO market that could suggest the economy is nearing the end of its historic growth cycle. New issues Peloton and Uber turned out to be flops (so far), while scheduled IPOs in WeWork and Poshmark were scrapped due to lack of investor interest.

Since initial public offerings convey important information regarding the overall strength of the economy, today we dissect the process of going public.

Every stock that trades on an exchange was once a private company that decided to sell shares to the public. This sale of partial ownership to outside investors is called an initial public offering or IPO. This action allows the original holders (founders, angel investors, venture capitalists etc.) to cash in on their early investments. It can also be an important source of funds to finance future growth.

But the IPO process is complex and costly, and should be untaken advisedly. New equity from initial offerings can be a source of substantial expansion funding, but is also the most expensive form of capital due to the high expenses and fees associated with getting to market. In addition, a public company must report financial statements and material developments to the public via filings with the SEC, limiting flexibility and adding to cost.

Once the decision to go public has been made, the company must select an entity called an investment bank to handle the transaction and market the shares. JPMorgan Chase, Goldman Sachs and BofA Securities are the largest U.S. investment banks, but hundreds more exist that may specialize in small- or middle-market companies.

The next step is regulatory due diligence. This involves filing a registration statement with the SEC that includes financial statements, management bios, proposed use of the funds, and disclosure of any relevant legal issues. Approval by the SEC does not constitute an endorsement, but certifies that all legal requirements have been met.

Next, an IPO date is set and the selling process begins. A summary document known as a preliminary prospectus (Latin for outlook or view) is filed with the SEC and disseminated to potential buyers. This preliminary document contains all relevant financial, management and legal information but no price or issue size. Because it is printed with a red stripe or on pink paper, it is referred to as a “red herring.”

Commonly, the investment bank will partner with competitors in a “syndicate” in order to spread the risk and increase potential sales penetration. The bankers and company management then go out to institutional and high net worth investors in a so-called road show, collecting indications of interest in buying the shares.

Shortly before the IPO date, a final prospectus including the offering price is filed with the SEC. On the date of the offering, the investment banks begin selling the shares to institutions and individuals at the specified price. For the first month, banks will support trading by buying or selling the shares to stabilize the market until trading volume picks up.

At this point, the company is considered to be public, and investors may trade shares on the exchanges in what is called the secondary market.

The failure of recent offerings and the faddish nature of some has raised concerns over the sustainability of the current expansion, and there have always been goofy IPOs during periods of exuberance. But a robust new issue market is essential to long-term health of the economy and the market over time.

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