An initial public offering, commonly known as an IPO, is the process of selling corporate shares in an open stock exchange for the first time. The underwriter is a financial specialist who specializes in IPOs and plays a critical role. The IPO is usually one of the rare make-or-break moments in the life of a firm, and its success or failure can have serious long-term ramifications.
Public vs Private
Every for-profit corporation has stockholders, since every firm is owned by someone. There is, however, a critical difference between a public and private corporation. A public firm is one whose stocks you can buy in an open exchange, such as the New York Stock Exchange. There is an openly displayed price at which the stock has just changed hands, and the stock's issuer must make financial data freely available. Shares of private firms, however, are held by far fewer individuals, and such companies aren't obligated to publish financial data. If you wish to buy shares of such firms, you must get in touch with one of the shareholders, who may or may not be willing to sell.
Companies almost always start their lives as private firms and "go public" after they grow. The process of going public, also known as the IPO, involves selling shares to a far larger audience than before and publishing financial as well as other strategic information for the world to see. A public firm must conform to many more regulations than a private company and must actively market its shares to a large number new investors, who may never have heard of the firm before. To help with this process, firms hire an underwriter.
The underwriter is usually an investment bank that employs IPO specialists. These bankers ensure that the firm satisfies all regulatory requirements, such as filing with the appropriate bodies and depositing all fees, and makes all mandatory financial data available to the public. Next, and perhaps most importantly, the underwriter contacts large prospective buyers of stock, such as mutual funds and insurance companies who have large sums of money to invest. The underwriter takes the pulse of prospective buyers and then recommends an IPO price to the firm. This is the price at which the shares will be sold. An excessive price may leave the firm with unsold stock, while a price that is too low will mean forgone revenue from the stock sale.
The underwriter usually provides a guarantee to the firm to sell a specific quantity of stock during the IPO process. Should the underwriter fail to convince prospective investors to buy this many shares, it must buy the surplus itself. To avoid having to commit large quantities of money to a failed IPO, the underwriter must therefore work especially hard to sell all available shares. Should the underwriter end up with a great quantity of stock, which it was forced to buy from the issuing firm, it will sell these shares in the open market. Such sales must proceed with caution, because suddenly dumping a lot of shares can drag the price down, hurting both the issuer as well as the underwriter.
- Hemera Technologies/AbleStock.com/Getty Images