Initial Public Offering (IPO's) is the first sale of stocks of a company which is made available to the public to raise capital for the company. Generally it's the smaller companies which go in for Initial public offering (IPO's) to expand their size but some large private companies also go in for Initial public offering (IPO's) to become publicly traded. An underwriting firm is generally associated with the company. They fix the date of issue of shares, the offer price, what kind of share to be issued like common or preferred etc.
Since only the smaller and newly formed companies generally go in for Initial public offering (IPO's) investing in them can be a risky proposition as there is no historical data to analyze their performance. How the stock will perform in future or what will be the opening price on the first day will be difficult to predict.
When the shares of a company are listed on the stock exchange, the capital which the company gets goes directly to the company. The advantage of an Initial public offering (IPO's) is that the company gets a huge amount of capital from the investors for future growth of the company. The company may again go in for a public issue to raise further capital for the company. The company doesn't pay back the initial capital to the investors, but the investors get a share in the profits of the company. The company can also come out with a rights issue which will further help in rising of capital at the same time increasing the value of the shares in absolute terms of the existing shareholders.
Generally one or more investment banks generally called underwriters are associated with the sale of shares. The issuing company called issuer enters into a contract with the lead underwriter to sell the shares to the public. If the Initial public offering (IPO's) is a large one, then there is a syndicate of underwriters with a lead underwriter who work on a commission basis based on the percentage of the value of shares sold.
Since there are a lot of legal formalities also involved, the Initial public offering (IPO's) also involve one or two law firms like the white shoe firm of New York City.
Public offerings are most sold to institutional investors but some shares are also allocated to retail investors. When there is an over allotment of shares, the issuer allows the underwriter to increase the size of offering by 15% which is known as the green shoe option.
In the late 1990s, in USA a lot of venture capital companies crashed in on the dotcom boom and came out with Initial public offering (IPO's) making many millionaires in the bargain. But inspire of this the companies faced a financial crisis later on as a lot of the companies liquidated the capital amount.
Investment banks have to consider many options before they arrive at a correct pricing of the shares. The pricing has to be low enough to attract investors and at the same time high enough to raise enough capital for the company. As under pricing though may prove beneficial to the investors who will get the shares at the offer price, the company may lose out in terms of more capital money being raised. Whereas in the case of overpricing, the underwriters may not be in a position to sell of their shares or in case of it being listed below the market price, then the credibility of the company goes down.
So the price of the Initial public offering (IPO's) is arrived at by the company either with the help of lead managers or through a process of book building.
Red Herring is the preliminary prospectus of the company, which describes the new issue of the stock and the prospects of the company. It is a registration statement which is filed with the SEC. The Red Herring doesn't contain any issue price in it. It is called the Red Herring as there is a paragraph is red which states that the company is not selling its shares to the public without registration with the SEC. (Securities and Exchange Commission).
After the company has gone public, the company usually enters into a contract with the investors say for a period of 90-180 days wherein those holding majority stakes in the company are not permitted to sell their shares. This is done so that the market is not flooded with too many of the company's shares which may send the share prices spiraling down. But once the lock-up period is over then the investor can dispose his shares.