Initial Public Offering (IPO): Everything you need to know

The experience of the English inventor Watt (around the end of the 18th century) clearly demonstrated that in order to build a manufacturing business, an ordinary citizen who is neither an oligarch nor a person close to the monarch never naturally accumulates enough money to build an entire enterprise.

Watt was greatly helped by the already developed credit system of Great Britain at that time: roughly speaking, banks gave him money. But not everyone can get a loan, and there are many more potentially profitable projects than an absolutely brilliant steam engine. What to do in this case?

The solution is simple and elegant: it is not at all necessary to take out a loan - funds can be raised. In other words, it is enough to throw out a cry: let investors who want to participate in the project counting on future dividends invest their money in it, receiving securities - shares. This is precisely the action that is called an IPO, and it is precisely this that I would like to talk about in more detail. So, IPO – what is it in simple words?

What is an IPO - the essence of the procedure

English The expression Initial Public Offering (or IPO for short) is the initial placement of a company's shares among an unlimited number of potential buyers on the stock market. In this way, the enterprise receives the capital it needs for development. And the larger the project, the larger the issue of shares, and the more people are involved in it through investing in the organized financial market.

It is the first public offering of its shares on the stock exchange that gives the emerging enterprise the much-needed money for the formation of fixed assets. And the value of this method lies in the fact that there are no debts: neither short nor long debt. Indeed, securities issued by a company - shares - can be of the following types:

• Ordinary shares (they do not guarantee dividends at all - the question regarding their size and the very fact of payment is decided at the annual General Meeting of Shareholders. And the decision, in fact, is made by the one who has more of these shares - the majority shareholders. But such shares provide the opportunity to accept participation in the company management process: for example, if you have more than 25% of the shares, then you can “push" your candidate onto the Board of Directors. However, this does not always require the ownership of shares - sometimes it is enough to form a coalition with other shareholders) ;
• Preferred shares (they do not take part in voting at the General Meeting of Shareholders, however, for each share the company is obliged to accrue and pay a certain rate of dividends, which is approved in the Charter of the enterprise at the time of registration of the issue. At its core, the issue of preferred shares is akin to a perpetual loan, all the beauty which lies in the fact that it can be obtained in the very first time of the company’s existence, when no sane bank would ever approve the slightest loan);
• Ordinary preferred shares (these shares “behave” as preferred shares in cases where the company’s management regularly pays dividends on them as prescribed in the Charter of the enterprise. However, if such payment to shareholders is denied, then their packages immediately gain a vote at the General Meeting Numerous games and intrigues in the field of corporate governance and property redistribution are associated with these shares, and it is the possibility of owning such voting shares that makes them more expensive compared to ordinary preferred shares, and their placement a more desirable move from the point of view of the founders of the enterprise ).

It would seem that this is the corporate Eldorado, where it is possible to implement any, even insanely capital-intensive, but reasonable and interesting idea literally from scratch! However, going public has a number of features that make it not such a way out for startups. More on this later.

Who are Underwriters

Underwriters (from the English “underwriter”) are the organizers of the attraction and placement of shares. Their role is played by banks, brokerage companies, stock exchanges

The right to be an underwriter is very prestigious, as it allows you to earn a decent fortune from raising funds and gain access to placements.

For their work on IPOs, underwriters charge a commission of up to 7% of the entire placement price. At the same time, she has the right to purchase part of the company at a preferential price.

Large companies most often conduct IPOs through the largest banks. For example, Twitter chose Goldman Sachs, Morgan Stanley and Morgan Chase. Google - Morgan Stanley and Credit Suisse, First Boston.

In most cases, IPOs are held on American and Asian sites. This is due to the fact that they simply have more money and funds. Therefore, here you can sell company shares faster and more expensive.

IPOs are also held in Russia, but much less frequently than in the United States. This is due to the small market.

The largest IPO was Rosneft in 2006 (raised $10.6 billion). In second place was VTB Bank in 2007 ($7.9 billion). For holders of VTB shares, they became a real failure, since their rate immediately fell and never returned to its original value of 13.6 kopecks. As a result, investors suffered heavy losses. After 6 years, VTB even carried out a special program to buy back shares at 13.6 kopecks for those who held them from the very beginning. It was a kind of “apology”. True, hardly any ordinary investor held VTB for so long.

Features of IPO

The first feature of such capital raising is that it is carried out exclusively on the organized financial market, that is, under the vigilant control of the state regulator (and indeed all parties involved in this procedure). And it was precisely the opportunity to collect enormous capital directly in the process of initial public offering that over time systematically bureaucratized this procedure, largely emasculating its main essence - the provision of financial resources for the formation of a capital-intensive business from scratch. Here, as usual, there are 2 factors:

1. risk of banal fraud;
2. ease of obtaining funds for entrepreneurs (start-ups).

The history of IPOs goes back to the distant 17th century. And in all those countries in which exchange trading developed and became civilized back in the 19th century (namely, these are the states we now call developed countries with market economies), everywhere there was a tendency to put a barrier to “organized” theft in organized markets, even if they sacrificed for this the availability of money for honest businessmen.

In other words, fear systematically defeated the feasibility and functionality of this procedure in general. And by now, in other countries, the laws governing the initial public offering of a company's securities have become so draconian that obtaining investments in this way is becoming an inaccessible task even for such rich and stable investors.

Simply put, it becomes not only more profitable, but simply more realistic to borrow money through the issue of bond issues than to attract it through the initial offering of one’s own shares.

So, the first feature of an IPO is the high administrative “barrier to entry.” The solvency of you and your business will be checked literally under a microscope by both the state regulator and the company that will be accredited to carry out the very procedure of issuing and placing a tranche of shares. Moreover, not only the obvious parameters of the company’s financial stability will be checked, but also indicators that, logically, should not at all affect the entrepreneurial “health” of the company. Eg:

• What does the presence of debts of the General Director and the Chairman of the Board of Directors of the company have to do with the general indicator of the riskiness of business? After all, their property is legally and, in fact, separated from corporate property. And here!
• The authorization of the issue is influenced by the company's liquidity indicators. Simply put, in order to attract money from the market, a company must either have significant savings in highly liquid assets, or it must already have a business that will allow it to quickly “fill the bins” if necessary. But excuse me, if you attract money from the market, then where will your “bins” even come from? And if you had them, wouldn’t it be easier to use them? However, firstly, the volume of financial liquidity should not be compared with the volume of issuing shares and raising funds, and secondly, the principle applies everywhere: if you want to get $10, first prepare $5.

So, as a second feature, we should highlight the actual inaccessibility of IPOs for start-up companies - they simply will not pass the administrative template on formal grounds. It is also obvious that small or even medium-sized companies should not attempt to participate in an IPO. Initial placement on the organized market is the prerogative exclusively of state-owned giants.

And finally, the third feature of an IPO is that with the help of an initial public offering they finance... not the first projects in the company. In 2006, VTB's IPO thundered in Russia. The sale of shares was carried out by preliminary closed subscription, and financial experts vied with each other to predict a sharp rise in the market value of the bank's shares after the completion of this event. It would seem that there were more shares (after all, Vneshtorgbank existed and was corporatized before), but it had no more projects, but nevertheless, analysts’ forecasts largely came true: VTB shares actually rose after the end of the initial offering. (True, not at all due to competent management within the company, but due to the global rally in commodity markets).

That is, at present, almost everywhere in the financial markets of various countries, IPOs are arranged by large players in order to carry out additional capitalization of their business. After all, only in this case will it be possible to count on passing the strict conditions of regulators and agents for organizing the procedure.

Investments in IPO. Features of investments

So, an IPO is a “toy” for corporate monsters, and small and medium-sized enterprises should not even think about going there. However, the general liberalization of the financial market, thanks to the emergence of such a thing as cryptocurrencies, has created opportunities for crowdfunding for them as well. We are talking about an ICO - an analogue of an IPO, which is carried out not on an organized stock market, but on a completely decentralized Internet.

But since we are talking specifically about the classical IPO procedure, it makes sense to consider it from the position of potential buyers of shares issued on the market. Why can this procedure be attractive? And knowledgeable exchange trading participants have something to lick their lips about here:

1. As mentioned above, an IPO is not so much an initial public offering as an additional one. That is, companies that are already fully established and have both impressive reserves of accumulated net profit and fairly confident cash flow from operating activities enter this procedure. And the fact that the current management is announcing an additional fundraiser means that they have been “struck” by some kind of entrepreneurial idea. Here we are talking about either some kind of breakthrough in the efficiency of current management, or the introduction of new technologies. In any case, there are achievements of a scientific, technological or management revolution. And it’s one thing when you invest your hard-earned money in the construction of the world’s first enterprise for the production of “steam rail carriages” (as was the case with the Englishman Stephenson at the beginning of the 19th century), and quite another if a new, potentially successful project is implemented on the basis already operating business, which will insure it in case of tactical failures during implementation. In this case, an increase in the cost of one share, even if their number increases significantly, is a completely logical consequence. After all, their buyers are well aware that the risks are reduced at least in proportion to the share of the new issue. But there is also a chance that the new project, under which funds from the IPO are aggregated, may take off, and the company will receive more income (part of which will be used for dividends). So it turns out that the risks for investors in this case are reduced, and the potential profitability jumps depending on the degree of optimism of each buyer. In any case, an IPO for buyers is a situation where they can “cut down” a more attractive risk/return ratio.
2. Additional additional capitalization for corporations (at least in developed countries) is:
   firstly , – a source of funds for the implementation of new projects;
3. secondly , a way to implement multi-move combinations in corporate games (after all, the repurchase of new shares changes the distribution of shares among current shareholders).

If with the first case everything is more or less clear, then corporate games need clarification. Imagine some kind of industrial enterprise (public joint stock company), whose shares belong to the second or even third echelon of liquidity. In practice, this means that the platform (for example, the Moscow Exchange) supports trading, but does not provide artificial 100% liquidity. That is, transactions with these securities occur extremely rarely and completely irregularly. But if suddenly, for some reason, this enterprise becomes interesting for an outside investor, then he begins to aggressively buy out existing stakes, and in addition, the standard move is to secure support for himself at the General Meeting in order to push through the issue of a new, additional issue (and its initial placement ). And there is no doubt that such an investor will try to buy out as large a stake as possible, reducing the number of shareholders. The result of these actions is an explosive increase in the value of securities that were previously of no interest to anyone.

Thus, a feature of subscribing to any IPO is a virtually guaranteed increase in the price of the shares of this enterprise. It is due either to a potential quick increase in the efficiency of the company, its acquisition of new opportunities, or to the acute political interest in it on the part of some investors. But one way or another, the price per share immediately after the end of the closed subscription (that is, after the completion of the registration procedure for the primary issue) invariably increases. What is being discussed is only the timing of such a price rise, but it is a fact.

Some speculators compare an IPO on the market to a supernova explosion in a galaxy - for a short time, the light of such a star outshines the radiation of the galaxy itself. Only in the case of the financial market does the glow mean a favorable risk/return ratio. And here you need to have time to collect all the cream from this event, since external forces are presenting you with such a gift.

Especially if the remaining potential buyers do not have enough liquidity to raise the subscription price above your expected values.

Who pays for the holiday

However, the rapid growth of the US stock market, especially in 2022, has allowed all categories of investors to make money. Even the most vulnerable and least profitable of them, namely those who bought shares immediately after their public offering, were able to double their holdings over the past year. A clear example of this is the dynamics of ETFs from the American company Renaissance Capital. It manages a fund that buys shares of listed companies on the fifth day of trading or after the release of the first quarterly reports. The graph shows that throughout 2022 and 2022, this strategy generated virtually no income, but in 2022 it brought in an impressive 110%. Now the chart looks as if the holiday of high yields has come to an end. At least for a while.

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The same company Renaissance Capital publishes statistics and reports on the IPO market.

The table shows that being the best client of an investment bank is still profitable. Such investors were able to earn an average of 44.29% based on the results of the first trading day. Investors who purchased shares from existing shareholders and are currently awaiting the end of the lockup can expect a potential return of 16.35%. And those who bought securities on the first day of public trading, on average today receive a loss of 16.64%. As soon as this category begins to suspect something is wrong, the whole scheme risks falling apart.

The banks' best friends will continue to earn money, but much more modestly. The banks themselves, as well as the brokers who ensure the operability of the infrastructure, will not be left without income. Neither one nor the other bears large market risks, but earns money from the flow of money passing through their hands. And the greatest risks will be taken by buyers of securities on the open market and those who buy them from existing shareholders with a lock-up period. Ironically, this is where the largest concentration of retail investor money is.

The stock market has many analogies to playing poker. The degree of success of players there is determined by two factors: professionalism and luck. During periods of euphoria, private investors compete in luck, often naively mistaking it for talent. And only during periods of corrections and collapses does it become clear who was actually making money all this time.

Professional poker players often say that if you don't understand who the victim is at the table, then the victim is you.

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The author's opinion may not coincide with the position of the editors

Disadvantages of an IPO

Oddly enough, the current legal situation, coupled with the opening of alternative opportunities for raising financing for small businesses, has almost completely eliminated the shortcomings of the IPO procedure. Nowadays, initial placement on the organized market is the most reliable procedure that can exist in nature.

Investors can be absolutely sure that the issuer issuing an additional share issue is a 100% reliable, highly liquid and solid enterprise in all respects, for the responsible behavior of which the state itself, represented by the stock market regulator, guarantees. The times of MMM and other “pyramids” are over, and now not a single public joint stock company will receive a “start in life” without a positive response from the placement agent (who is responsible for it with his license as a professional participant in the financial market).

Yes, post-subscription stock price jumps may no longer be as dramatic as they were during the formation of the many Wild West railroad companies in the United States, but for those buyers who are hungry for greater returns and are not averse to taking risks, there is an endless field of ICOs where there are no regulators at all, except the conscience of the issuers themselves. However, this “risk norm” does not stop many people at all.

Summary

So, IPO – what is it in simple words? This is an initial placement of shares by corporations on the organized market, which is now carried out, as a rule, to carry out additional capitalization of the enterprise, because “start-ups” are not allowed to enter the IPO. However, for small and medium-sized enterprises there is an informal institution of crowdfunding through access to ICO (on numerous cryptocurrency exchanges).

In general, if you want maximum security and transparency, but at the same time you are willing to put up with the relatively moderate profitability of speculative operations in shares (on spot), then as an investor, you should go for an IPO. If you prefer the unlimited potential for the price of tokens to skyrocket after the end of their placement, then ICO is for you.

Igor Titov

Economist, financial analyst, trader, investor. Personal interests – finance, trading, cryptocurrencies and investing.

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