A Guide to the Initial Public Offering ProcessKatrina Ellis(kle3@)Roni Michaely(rm34@)andMaureen O’Hara(mo19@)January 1999*All Authors are from Cornell University, Johnson Graduate School of Management,Cornell University Ithaca NY 14853. Michaely is also affiliated with Tel-Aviv University.
A Guide to the Initial Public Offering ProcessA milestone for any company is the issuance of publicly traded stock. While themotivations for an initial public offering are straightforward, the mechanism for doing so iscomplex. In this paper, we outline the process by which companies are brought to marketin an initial public offering. Our goals here are to delineate the specific steps that arerequired in an IPO, to demonstrate the complex inter-relationships between the advising,marketing, pricing, and trading functions of the IPO process, and to highlight the roleplayed by the underwriter in a public a company wishes to make a public offering, its first step is to select aninvestment bank to advise it and to perform underwriting functions in connection with theissue. The selection process relies on the investment banker’s general reputation andexpertise as well as on the quality of its research coverage in the company’s specificindustry. The selection also depends on whether the issuer would like to see its securitiesheld more by individuals or by institutional investors (., the investment bank’sdistribution expertise). Prior banking relationships the issuer and members of its board(especially the venture capitalists) have with specific firms in the investment bankingcommunity also influence the selection outcome. Often, the selection process is a two-wayaffair, with the reputable investment banker choosing its clients at least as carefully as thecompany should choose the investment most common type of underwriting arrangement involved with large issues isthe “firm commitment” underwriting. In a firm commitment underwriting, the underwriterpurchases the entire issue of securities from the issuer and then attempts to resell the
securities to the public. The difference between the price at which the underwriter buysand subsequently sells the issue is called the gross offerings can be managed by one underwriter (sole managed) or by multiplemangers. When there are multiple managers, one investment bank is selected as the lead orbook-running manager. The lead manager almost always appears on the left of the coverof the prospectus, and it plays the major role throughout the transaction. The managingunderwriter makes all the arrangements with the issuer, establishes the schedule of theissue, and has the primary responsibility for the due diligence process, pricing anddistribution of the stock. The lead manager is also responsible for assembling a group ofunderwriters (the syndicate) to assist in the sale of the shares to the public. Members ofthe syndicate are paid a portion of the gross spread for their lead underwriter, the co-managers and the syndicate members all receivecompensation from the company for being involved in the IPO process. This compensationcomes from the gross spread—the difference between the price the securities are boughtfrom the issuer, and the price for which they are delivered to the public. The leadunderwriter receives a fee for its efforts that is typically 20% of the gross spread. Thesecond portion of the spread is called the “selling concession”, and it is the amount paid tothe underwriter and other syndicate members for actually selling the securities. This istypically equal to 60% of the gross spread. Each syndicate member receives a sellingconcession based on the amount of the issue it sells to its customers. Institutionsoccasionally directly designate the selling concession credit associated with their stockpurchase to a specific syndicate member regardless of who actually sold the stock. These2
designated orders usually arise as compensation for research services performed byinvestment houses. The remaining portion of the gross spread (approximately 20%) isused to cover underwriting expenses (underwriter counsel, road show expenses, etc.). Ifanything remains after deducting all expenses, it is divided proportionately among theunderwriter and syndicate members depending on the amount of securities of the lead underwriter’s first-agenda items (usually before any significantexpenses have been incurred) is to draft a letter of intent. Indeed, an important aspect ofthe letter of intent is to protect the underwriter against any uncovered expenses in theevent the offer is withdrawn either during the due diligence and registration stage, orduring the marketing stage. Thus, the letter of intent contains a clause requiring thecompany to reimburse the underwriter for any out-of-pocket expenses incurred during theprocess. Another important aspect of the letter is the gross spread or the underwritingdiscount. In most cases, the gross spread is 7% of the proceeds (see Chen and Ritter, 1998for an excellent discussion of the uniform size of the gross spread). The letter alsotypically includes: a commitment by the underwriter to enter into a firm commitmentagreement (or other underwriting agreements, as the case may be); an agreement by thecompany to cooperate in all due diligence efforts, and to make available all relevantinformation to the underwriter and its counsel; and a commitment by the company to granta 15% overallotment option to the is important to note that there is no guarantee of the final offering price (and, inmost cases, no mention of any valuation) in the letter of intent. The letter of intent remains3
in force until the Underwriting Agreement is executed at pricing. Only then is theunderwriter firmly committed to buy the securities at a specific price from the issuer. Bythat point, the underwriter has good indications on how successful the deal is and at whatprice the market will be willing to buy the deal. This knowledge allows the underwriter todetermine a price for the Securities Act of 1933 mandates that the company and its counsel draft aregistration statement for filing with the SEC, based upon an outline frequently providedby the lead underwriter. It usually takes several weeks and many meetings of the workinggroup (the company management, its counsel and auditors, the underwriters, theunderwriters’ counsel and accountants) before the registration statement is ready to registration statement is circumscribed by Section 5 of the Act, which gives specificrequirements for the registration s1t aTtheem statement consists of twoparts: the prospectus, which must be furnished to every purchaser of the securities, and“Part II” which contains information that need not be furnished to the public but is madeavailable for public inspection by the purpose of the registration and disclosure requirements is to ensure that thepublic has adequate and reliable information regarding securities that are offered for sale. 1 The power of Congress to enact legislation regulating securities transactions is based in the CommerceClause of the constitution. The Commerce Clause which is Acortnictalein Ie, dS einction 8 of theconstitution gives Congress the power “to regulate commerce … among the several states …” So long asa transaction makes use of “any means or instruments of transportation or communication in interstatecommerce”, it will fall within the reach of the federal securities laws. This includes the use of telephonesand the mails. It is rare that a transaction will not use some instrumentality of interstate commerce andwill thus fall outside the reach of the law. In addition, Congress has given the Securities and ExchangeCommission the authority to administer the securities laws and to promulgate rules and regulations tosupplement its enforcement powers. These additional rules are necessary to clarify statutes that are vagueor ambiguous or to make substantive additions to the statutes so long as they are not inconsistent with thelegislatively enacted statutes. In addit ifoend etora tl hleaws, the states all have their own securities laws,4
To achieve this, the underwriter has a “due diligence” requirement to investigate thecompany and verify the information it provides about the company to investors. TheSecurities Act also makes it illegal to offer or sell securities to the public unless they havefirst been registered. It is important to note, however, that the SEC has no authority toprevent a public offering based on the quality of the securities involved. It only has thepower to require that the issuer disclose all material facts. As a safeguard, the SecuritiesAct requires that the registration statement be signed by the directors and principal officersof the issuer as well as the underwriters, accountants, appraisers and other experts whoassisted in the preparation of the registration statement. Any purchaser of the securitieswho is damaged as a result of a misstatement or omission of a material fact in theregistration statement may sue these s2 i gSnuactho -based lawsuits havebecome commonplace in recent the registration statement is filed with the SEC, it is transformed into thepreliminary prospectus (or “Red Herring”.) The preliminary prospectus is one of theprimary tools in marketing the issue. Within 20 days, the SEC responds to the initial filingand declares the issue eff3e Act stage, the red herring is amended and transformedinto a prospectus, which is the official offering document. During the period after thefiling, the SEC examines the registration statement and engages in a series ofcommunications with issuer’s counsel regarding any changes necessary to bring about which are known as “blue sky” laws. The federal securities laws have permitted states to retain their rightto regulate intrastate securities transactions so long as their regulation does not conflict with federal Sections 11 of the Securities Act of 1933 imposes civil monetary liability against persons who fail toestablish “due diligence”. Section 12 of the Act provides that a purchaser may recover damages againstany person who offers or sells a security in violation of Section 5 (the registration requirements).3 Section 8 of the Securities Act of 1933 details the process by which the registration statement
SEC approval. If the changes are minor, they are included in the “price amendment”; ifthe changes are extensive, a new prospectus is prepared and there gistration statement is approved by the SEC, the marketing of theoffering begins. Often the Red Herring is sent to sales people as well as to institutionalinvestors around the country. At the same time, the company and the underwriter promotethe IPO through the road show, in which the company officers make numerouspresentations to (mainly) institutional investors. A typical road show lasts 3-4 weeks andincludes two or more meetings a day with both retail salespeople and the road show progresses, the underwriter receives indications of interest frominvestors. The indications of interest by individual investors and by institutions differ alongseveral dimensions. First, retail investors typically submit a “market order” in which onlythe quantity desired is stated. Institutions, on the other hand, typically submit limit orderswhere the quantity demanded is subject to a maximum price. Second, retail orders arereceived earlier than institutional orders since institutions prefer to wait to a later stage ofthe process before submitting their orders. Third, in some cases, institutions submit anorder with a commitment to purchase more shares in the open market if their order isfulfilled. These differences in turn may affect the investment bank marketing , regardless of the source of the indication of interest, at this stage, prior to theeffective day, no shares can be officially sold, so any orders submitted are only indicationsof interest and are not legally
The registration and marketing process can take several months, and it is thereforeimpossible for the underwriter to include certain information (such as the final IPO price,the precise discount to the dealers, and the names of all the syndicate members) in itsinitial filing with the SEC. Once the registration statement has been approved and deemedeffective, the underwriter files with the SEC an acceleration request, asking the SEC toaccelerate the effective date of the registratio4n Usstuaatellmy ethnet. issuer assessesmarket conditions and chooses what it considers to be the optimal effective the day prior to the effective date, after the market closes, the firm and the leadunderwriter meet to discuss two final (and very important) details: the offer price and theexact number of shares to be sold. Particular attention during the pricing decision is givento the order books (where institutions and other investors’ indications are recorded).Discussions with investment bankers indicate that they perceive that an offer should betwo to three times oversubscribed to create a 5“ g oTohde rIeP Ois” .extensive evidence(see, for example, Ritter (1991)) that IPOs tend to be “under-priced”. This means thatinvestors in an IPO can expect the price to rise on the offer day, a characteristic thatenhances demand for the issue. From the company’s perspective, such under-pricing“leaves money on the table” in the sense that the company is not getting the full value forits shares, but it may be preferable for the company if it guarantees that the issue succeeds. 4 It is at this point that the issuer needs the cooperation of the SEC. Since the law provides that the filingof an amendment (in this case the price amendment) starts the 20-day waiting period running again, theissuer must make a “request for acceleration” which asks the SEC to exercise its discretion and waive the20-day period. Ordinarily, an issuer does not want to wait for 20 days because during this time marketconditions could change dramatically. Thus, the threat of denial of acceleration usually leads the issuer tocooperate with the SEC and it enables the SEC to get the issuer to make changes to the registrationstatement, which it might not be able to force under the
After those final terms are negotiated, the underwriter and the issuer execute theUnderwriting Agreement, the final prospectus is printed, and the underwriter files a “priceamendment” on the morning of the chosen effective date. Once approved, the distributionof the stock begins. On this morning, the company stock opens for trade for the first closing of the transaction occurs three days later, when the company delivers itsstock, and the underwriter deposits the net proceeds from the IPO into the firm’s the IPO is far from being completed. Once the issue is brought to market, theunderwriter has several additional activities to complete. These include the after-marketstabilization, the provision of analyst recommendations, and making a market in the stabilization activities essentially require the underwriter to support the stock bybuying shares if order imbalances arise. This price support can be done only at or belowthe offering price, and it is limited to a relatively short period of time after the stock hasbegan trading. Interestingly, during this period, the standard prohibitions against pricemanipulation do not apply to the underwriter, and he is free to trade so as to influence theprice of stock. (See Ellis Michaely and O’Hara, 1999a, 1999b for an in-depth analysis ofthe underwriters activities in the post-IPO period). In general, the underwriter willcontinue to actively trade the stock in the months and years following the offering. By“making a market in the stock”, the underwriter essentially guarantees liquidity to theinvestors, and thus again enhances demand for the final stage of the IPO begins 25 calendar days after the IPO when the so-called “quiet period” enTdhsis. “quiet period” is mandated by the SEC, and it marks a 5 This “pricing meeting” will never be held on Friday since the underwriter does not want to take the riskof pricing a firm on Friday and being able to sell the firm only on Monday. Indeed, there are practically8
transition from investor reliance solely on the prospectus and disclosures mandated undersecurity laws to a more open, market environment. It is only after this point thatunderwriters (and other syndicate members) can comment on the valuation and provideearnings estimates on the new company. The underwriter’s role thus evolves in this after-market period into an advisory and evaluatory function (see Michaely and Womack (1998)for an evaluation of the role of the underwriters’ post-issuance recommendations).The initial public offering process thus involves a complex combination of tasks bythe company, the underwriter, and the syndicate members. Throughout the process, thecompany relies on the underwriter’s expertise to market, price, distribute, stabilize, andsupport the issue, while the underwriter relies on the information and integrity of thecompany. The completion of the process provides new capital for the firm, and a newinvestment opportunity for the public. no firm commitments IPOs on
ReferencesAggarwal, R., 1998, “Stabilization Activities by Underwriters after New Offerings,”Working Paper, Georgetown . H. and J. Ritter, 1998, “The seven percent solution,” Working Paper, University ofFlorida, Gainesville, , K, R. Michaely, and M. O’Hara, 1999a, “When the underwriter is the market maker:An examination of trading in the IPO Aftermarket,” Working Paper, Cornell University,Ithaca , K, R. Michaely, and M. O’Hara, 1999b, “The market microstructure of IPOs”, Workin progress, Cornell University, Ithaca , R. and K. Womack, 1998, “Conflict of interest and the credibility of underwriter Working Paper, Cornell University, Ithaca , J., 1991, "The Long-Run Performance of Initial PublicJ Ooufrfenariln ogfs," Finance 46,
Biographical summaries:1. Katrina Ellis is completing her doctorate degree in Finance at the Johnson Graduateschool of Business at Cornell University. Her research interest are in the area ofCorporate Finance and Market Micro-structure2. ProfessoMr ichaely’s research interests are in the areas of corporate finance, capitalmarkets and market microstructure. His current research focuses on the pricing ofIPOs, theirlo ng term performance and firms’ financial policies. His research hasappeared in Journals likJeo uthrnea l of Finance, theR eview of Financial Studies andFinancial Management. His research has been frequently fetahteu Wreadll iSnt reetJournal, theN ew York Times, theE conomist, Forbes and . Professor Maureen O’Hara specialties are in the area of the structure of the securitiesmarket. Recent work includes an examination of the optimal regulation of exchangesand alternative trading systems. Professor O’Hara has recently been named theExecutive Editor of Rtheveie w of Financial Studies, and she is the past president ofthe Western Finance Association and a member of the Economic Advisory Board ofthe NASDAQ. Her research has appeared in a wide range of Journals including theAmerican Economic Review, theJ ournal of Finance, theR eview of Financial Studies,the Journal of Financial Economics, and th Berookings Papers on Financial
