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Initial Public Offering: CNBC Explains

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An initial public offering—or IPO as it's most commonly called—is the process by which companies go from private to public and sell stocks shares in their firm.

IPOs don't happen overnight and take a lot of effort to put together. So here's a look at how the IPO procedure works, as CNBC explains.

What is an IPO?

If a company wants to sell stock shares to the general public, it conducts an IPO. By doing so, a company goes from the status of private (no general shareholders) to public (a firm with general shareholders).

Private companies can have shareholders, but they are few in number and they and the firm are not subject to regulations by the Securities and Exchange Commission. This changes dramatically with an IPO, as we'll see later.

An IPO usually takes three to four months from the beginning to the first day's trading on an exchange.

Why does a company go public?

It's simply a money-making move. The idea is to raise funds and have more liquidity or cash on hand by selling shares publicly.

The money can be used in various ways, such as re-investing in the company's infrastructure or expanding the business.

An added benefit from issuing shares is that they can be used to attract top management candidates through the offer of perks like stock option plans.

Another plus from going public benefit is that stocks can be used in merger and acquisition deals as part of the payment.

There's also the prestige—bragging rights for some firms—of being listed on a major stock exchange like the NYSE or Nasdaq.

What's the first step in an IPO?

The firm going public hires an investment bank, or banks, to handle the IPO. It's possible for a company to sell shares on its own but, in reality, that never happens.

Investment banks can work alone or together on one IPO, with one taking the lead. They usually form a group of banks or investors to spread around the funding—and the risk—for the IPO.

Banks submit bids to companies going public on how much money the firm will make in the IPO and what the bank will walk away with. The process of an investment bank handling an IPO is called underwriting.

When an investment bank, like Goldman Sachs or Morgan Stanley is eventually hired, the company and the investment bank talk about how much money they think they will raise from the IPO, the type of securities to be issued, and all the details in the underwriting agreement.

What happens next?

After the company and investment bank agree to an underwriting deal, the bank puts together a registration statement to be filed with the SEC.

This statement has detailed information about the offering and company info such as financial statements, management background, any legal problems, where the money is to be used, and who owns any stock before the company goes public.

The SEC will investigate the company to make sure all the information submitted to it is correct and that all relevant financial data has been disclosed.

If everything is OK, the SEC will work with the company to set a date for the IPO. After SEC approval for the IPO, the underwriter must put together a prospectus; that is, all financial information on the company that's doing the IPO.

How do underwriters make their money?

A bank or group of banks put up the money to fund the IPO and 'buys' the shares of the company before they are actually listed on a stock exchange. The banks make their profit on the difference in price between what they paid before the IPO and when the shares are officially offered to the public.

Competition among investment banks for handling an IPO can be fierce, depending on the company that's going public and the money the bank thinks it will make on the deal.

What part of an IPO is a road show?

To try and drum up interest in the IPO, the underwriter takes the prospectus and presents it to prospective investors. This is what's called a road show. These can be trips around the world—thus the name road show—or can be video or internet presentations.

If a prospective investor likes the IPO, underwriters can legally offer them shares at the price they eventually set before the stock is listed on an exchange. This is called IPO allocation.

Road shows are usually for the bigger institutional investors like pension funds, rather than an individual investor.

How is the price of the IPO stock determined?

As the IPO date comes closer, the underwriter and company decide on the price. This can depend on the company, the success of the road show and current market conditions.

Recent transactions on the private market put estimates of the price of a single Facebook share at between $38 and $40.

What determines which exchange gets a new stock listing?

Like underwriters, stock exchanges such as the Nasdaq and NYSE want the business of an IPO. That's because it could lead to more trading and future business from other IPOs. There's also the prestige of having a famous company listed.

Exchanges make pitches to the companies. Then the firm with the underwriting will make the final selection.

How do investors get in on an IPO?

For small investors, it's nearly impossible to get any kind of IPO allocation. They usually have to wait until the stock is listed on an exchange, unless they have a very large account with the bank or banks doing the underwriting. Only then would they be offered some shares.

Many market experts say that the small investors should wait and refrain from immediately buying shares of an IPO. That's because insiders, such as hedge fund managers, are buying up shares that push up the price.

Smaller investors are advised to wait a couple of days for the stock price to settle back down.

What happens legally when a firm goes public?

The company falls under the guidelines of the SEC.That means it will have to follow disclosure rules like holdings and transactions of insiders or the officers and directors of the company.

It will have to disclose its financial status on a regular basis and come under surveillance by the SEC on its trading practices. And it will have to hold shareholder meetings.

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