What is an IPO?
An initial public offering (IPO) is when a private company offers shares to the public for the first time.
This allows the company to raise additional equity capital from the public provided it meets the requirements of the stock exchange it wishes to list on, such as the ASX.
Many growing and successful private companies consider listing on the ASX via an IPO at some stage. A successful listing and IPO can accelerate growth and open up new business opportunities. The process can help raise the profile of a company as it transitions to the public market. Private equity and venture capital investors often work towards an IPO as an exit mechanism for their investment.
An IPO can also improve the liquidity of a company’s shares, which can be helpful to its management in several ways. It can allow founders, executives, or staff to easily offload their existing shares without having to find a private buyer. It can also facilitate a company offering shares or stock options as part of their staff remuneration.
What’s the difference between an IPO and a direct listing?
A company wishing to list on the ASX can do so via an IPO or a direct listing. In an IPO, new shares are offered to the public. The company therefore sells part of itself by issuing new shares. In a direct listing, existing shares held by current investors are sold to the public, but new stocks are not issued. A direct listing allows companies to become listed on the ASX without raising additional equity capital.
Companies that undertake a direct listing generally have different goals from companies conducting IPOs. A direct listing increases liquidity for existing shareholders but does not raise additional capital for the company. A company that undertakes a direct listing will still enjoy the other benefits of going public, such as increased public awareness and institutional interest in the company.
Unlike an IPO, a direct listing does not utilise the services of underwriters. This means the costs of a direct listing are generally lower than those of an IPO. But it also means the company conducting the direct listing has to be attractive enough for the market. Companies that can consider direct listings often have a strong brand identity and easy-to-understand business model and do not require additional capital.
The result of an IPO or direct listing is that shares in the issuing company are available to trade on the stock market. Once this occurs, any individual investor or retail investor with a trading account can purchase shares in the company.
Why go public?
Going public via an IPO means you can raise capital quickly by reaching numerous investors, which you can then use to expand your business.
IPOs provide an opportunity to generate publicity and benefit from the prestige of being listed on a major stock exchange.
Companies can also use the lure of stock options to attract high-quality employees to their business.
Underwriters and the IPO process
The IPO process requires an underwriter — usually an investment bank. They work closely with the company conducting the IPO to help it prepare.
The underwriter will assist with determining the amount of money to be raised, the type of shares to be issued, and preparing the relevant offer documents required by the exchange. The underwriter will determine the offer price of the shares, buy the shares from the company, and sell them to investors via their distribution network.
Conducting an IPO
Steps involved in conducting an IPO include:
- Appointing advisors, including an underwriter, legal counsel, accountants, and technical experts
- Considering and deciding on the structure of the initial public offering
- Determining whether the company can meet the listing requirements of the relevant stock exchange (the ASX in Australia)
- Conducting IPO due diligence to ensure the prospectus contains the information required by law and does not contain any false or misleading information
- Preparing disclosure documents, including the prospectus and marketing materials for potential investors
- Undertaking any required pre-IPO restructuring
- Commencing marketing to institutional investors to generate interest in the offer
- Lodging the prospectus with the relevant governing body (the Australian Securities & Investments Commission (ASIC) in Australia)
- Applying for admission to the official list with the relevant stock exchange (the ASX in Australia)
- Processing of the listing application by the relevant stock exchange
- Commencing marketing to retail investors, who brokers from their retail distribution networks usually solicit
- Opening and closing of the offer period
- Funding becomes available to the company, the IPO shares are issued, and trading commences on the stock exchange.
The direct listing process
Where a company chooses to undertake a direct listing rather than an IPO, it will have to follow a similar process, including:
- Appointing advisors (likely including the advisory services of an investment banker)
- Considering and deciding on the structure of the direct listing
- Determining whether it can meet the listing requirements of the stock exchange
- Preparing disclosure documents – the ASX Listing Rules require a prospectus to be lodged with ASIC for admission to the official list, however where the listing does not involve a capital raising, the ASX may agree that an information memorandum is sufficient
- Lodging the disclosure documents and making an application for listing
- Processing of listing application
- Trading commencing on the stock exchange.
Advantages of conducting an IPO
An IPO can result in a significant cash windfall for a company as a result of selling ownership. This can be used to invest in expansion, pay debt, or pursue acquisitions.
Other advantages of being listed on a stock exchange include the following:
- Broader access to the investing public to raise future capital
- An increased ability to fund acquisitions using scrip rather than cash
- Lower costs of capital for equity and debt
- Raising the profile of the company
- Allowing early investors to exit (although where an IPO is conducted, there are likely to be restrictions on the number of shares that early investors can sell for a period after listing).
Disadvantages of conducting an IPO
Of course, there are some disadvantages to consider as well. These include:
- The expenses associated with conducting an IPO or direct listing, which can be considerable
- Ongoing disclosure requirements imposed by the stock exchange, which mean financial, accounting, tax, and other business information must be disclosed
- The disclosure obligations that apply to public companies can result in increased legal, accounting, and management costs
- A potential loss of control for owners of the company arising from dilution and the need for shareholder approval under the ASX Listing Rules
- The diversion of management focus that an IPO or direct listing will necessitate, which, if not carefully managed, can impact the underlying business.
Some companies may consider the pros and cons of pursuing an ASX listing and instead decide to pursue an alternative, such as remaining private or soliciting bids for a buyout.
Lock-ups and flipping
Lock-ups are used to prevent company insiders from selling shares when a company ‘IPOs’. They usually apply to a company’s founders, owners, managers, and early investors. These insiders are prohibited from selling their shares for a period of time after the IPO.
Lock-ups can help grease the wheels for an IPO by making sure a large volume of shares are exempt from being sold upon listing. This may help prevent initial dips in the share price when a company does IPO.
Flipping is when you invest in an IPO and exit quickly, which some retail investors or institutions may be able to do.
This usually involves determining that a share’s set IPO price is below the company’s valuation. Getting on the right side of this equation can potentially result in a healthy profit on IPO day. This can make IPO investing lucrative for initial investors.
Recent IPOs
IPOs have been around for as long as stock exchanges, so they’re likely to remain a key common channel for public capital raisings for the foreseeable future.
The very concept of the IPO has been expanding in recent years. The cryptocurrency world has its own version of an IPO — the initial coin offering (ICO), sometimes called the initial token offering (ITO).
The year 2021 was a record year for ASX listings, coinciding with the share market reaching all-time highs thanks to fiscal and monetary stimulus. There were 240 new listings on the ASX in 2021, which raised more than $13 billion in capital.
Some of the most significant listings included GQG Partners Inc (ASX: GQG), APM Human Services International Ltd (ASX: APM), Pexa Group Ltd (ASX: PXA), and Latitude Group Holdings Ltd (ASX: LFS).
The year 2022 was quieter for ASX listings, with inflation and tightening monetary policy weighing on the stock market.
The performance of companies that IPOed on the ASX in 2022 has been mixed. Some companies have seen their share prices more than double, but others have recorded significant losses against their issue price. Examples of 2022 IPOs include Lottery Corporation Ltd (ASX: TLC), Leo Lithium Ltd (ASX: LLL) Belararox Ltd (ASX: BRX), and Lithium Plus Minerals Ltd (ASX: LPM). The ASX publishes details of each upcoming IPO.
Investing in IPOs
Like all investments, investing in IPOs or direct listings involves risk.
However closely you study the disclosure documents, the reality is that the performance of a newly-listed company cannot be precisely predicted. Any number of factors (including factors outside a company’s control) can impact the performance of both listed and unlisted companies. These may be economy-wide (such as a pandemic or recession) or changes affecting a specific industry.
As such, we tend to see various outcomes for different IPOs. Some become incredible success stories, but others prove to be spectacular failures.
Valuing a company is a complex and demanding task at the best of times. But valuing a company that is pursuing an IPO is even more challenging. Companies that conduct IPOs tend to be younger companies in their growth phase. Some are not even profitable yet.
This makes using traditional valuation metrics like the price-to-earnings (P/E) ratio very difficult. Instead, investors must look at other metrics like revenue growth, customer retention, and brand strength. While these numbers are helpful, they do not guarantee future profits.