How is an initial public offering (IPO) priced?

Setting the right IPO price is a critical juncture for companies stepping onto the public stage. It involves a strategic interplay between anticipating investor appetite and accurately reflecting the company's value.

Let's explore in this article, a clear exploration of the meticulous process involved in crafting an IPO price, setting the stage for a company's robust debut in the market.

I'll help you understand the essentials of IPO pricing, a fundamental aspect for investors and companies alike as they prepare to meet on the trading floor.

What is the IPO price?

The IPO price is set for a company's stock before it hits the public market, aimed at drawing investors to purchase the shares.

Investment banks play a key role here, they take on the task of underwriting the stock, which means they handle the details of the offering and ultimately set the IPO price.

They base this crucial number on a mix of factors, they assess the company's potential for growth, compare it with similar companies, and gauge the market's current appetite for new stock.

It's important to recognize that investing in IPO stocks comes with significant risk. Despite the potential for impressive growth, there's no surefire promise of profits.

Investors need to research thoroughly before buying in, examining the company's financial health, business model, and the broader industry landscape.

The banks that underwrite the IPO have a significant responsibility. They must not only ensure that the IPO price reflects the company's value but also that it's enticing enough for investors without being undervalued.

A well-priced IPO can mean a strong start for a company on the stock exchange, which is why the expertise of these financial institutions is crucial.

The IPO price serves as the first critical test of a company's stock in the financial arena. It's the initial handshake between the company seeking public investment and the investors looking for new opportunities.

With a sound pricing strategy, a company can lay the foundation for a strong relationship with the public market and its new shareholders.

Why do companies decide to go public?

Companies typically go public primarily to secure capital. An IPO can be a financial windfall, potentially raking in millions or even billions of dollars.

However, the flip side is that not all IPOs are successful and some companies might incur losses. Public investment doesn't just fill the company's coffers; it also pays off for the early backers.

These initial investors, who have supported the company through its ups and downs, get the chance to sell their stakes once the company goes public, often reaping substantial rewards for their early faith and investment.

Employees stand to gain from an IPO as well. Many companies offer stock options to their employees as part of their compensation package.

Through vesting, employees earn the right to exercise these options over time. Post-IPO, there's typically a lock-up period during which employees can't sell their shares. Once this period ends, they're free to sell and potentially profit.

The visibility that comes with an IPO is another significant advantage. It helps in drawing media attention, expanding the investor base, and often leads to a financial boon for the venture capitalists who have funded the company's growth.

Entities involved in determining the price of an IPO

When a company decides to enter the public market, it usually aims to raise funds and realise the value for early investors by going public. Successful companies leverage the raised funds to expand and improve their operations through capital investments and strategic acquisitions. At the same time, early investors get a chance to sell their stakes.

An investment bank is often the partner company's choice when they decide to list on the stock market. The bank's role is to provide guidance and handle the complexities of the public offering.

One of the key responsibilities of an investment bank is to underwrite the IPO. During underwriting, the bank may buy all or part of the IPO shares, acting as a guarantor of sorts, to ensure the offering succeeds.

Method used to price an IPO

• Guaranteed purchase: In a guaranteed purchase scenario, the investment bank promises to buy all the shares at a price they determine with the company selling the shares. The bank aims to sell all these shares to investors and earns a fee from the company based on a percentage of the total funds raised, typically around 5.5%.
• Best-effort agreement: A best-effort agreement means the bank will attempt to sell as many shares as possible but doesn't commit to buying them upfront. If the minimum number of shares isn't sold, the offer may be withdrawn without any cost to the company.https://www.markets.com/education-centre/how-to-trade-ipos-3-ways-trade-ipo-stocks-marketsx/
• Auction process: In an auction-based IPO, the price is set through bids from investors before the shares are publicly listed. This competitive bidding reduces the investment bankers' influence and typically results in lower fees. Google's IPO in 2004 is a prime example of a successful auction IPO where the underwriting fees were significantly lower due to the auction format.
• Direct listing: Alternatively, a company might opt for a direct listing, where shares are sold directly in the market without underwriters. The price is then determined by market demand and supply dynamics. For instance, Coinbase chose this route for its April 2021 public offering.

Related: How to trade IPOs – 3 ways to trade IPO stocks with Marketsx

Steps involved in setting the IPO price

The process of setting an IPO price unfolds through a series of deliberate and strategic steps. It is an intricate dance of analysis, forecasting, and negotiation that aims to establish a fair market value for a company's shares as it prepares to go public.

From assessing the company's financials to gauging investor appetite, each step involves careful consideration to arrive at a price that satisfies both the company seeking capital and the investors seeking opportunity.

The journey to determining an IPO price is a blend of art and science, where market savvy meets financial rigour to set the stage for a company's debut on the stock exchange.

1.   Initial price assessment

Setting an IPO price kicks off with an in-depth evaluation of the company. The goal is to compile a registration statement for the SEC.

The first part of this statement, the prospectus, gives potential investors the essential details about the company's operations, the upcoming offer, and the leadership team.

The second part offers additional details for the SEC, covering the costs and commissions involved.

Multiple teams are integral to this phase. The company's lawyers draft the statement and maintain dialogue with the SEC.

Accountants are busy auditing the company's financials for inclusion. Meanwhile, the investment bankers dive into the financial details, market dynamics, the company's market position, strategy, and competitors.

They also predict how the influx of new capital will influence the company's scale and profitability.

2.   Marketing the offering

With the statement submitted, bankers move to the book-building phase. This involves drumming up interest for the shares and collecting informal commitments from potential investors. Effective marketing is crucial as it informs the market about the share value.

Book building involves roadshows designed to drum up excitement and interest. This could be a mix of investor conference calls, one-on-one meetings, and online information releases.

Each roadshow often includes a Q&A, offering a window into the company's leadership vision and prospects.

Crucial in this process are the in-person meetings organised by the investment bank with big-ticket investors, where high-level executives from the company engage directly with potential major investors.

3.   Setting the final price

Bankers finalise the IPO price by evaluating the market's interest and reactions from the roadshows. The legal team then requests the SEC to set an effective date for the registration, and the company's directors sign off on the final offer price.

Once the SEC gives the green light, investors receive their share allocations at the set price. The company makes its official entry into the stock market on the day it lists.

Wrapping up

The IPO price marks a pivotal moment for a company, reflecting its market value as it offers shares to the public for the first time.

By understanding the complexities and strategies behind this pricing, investors can better navigate the prospects of investing in a newly public entity.

The path to setting an IPO price is multifaceted, designed to establish a fair starting point that benefits both the company and its new shareholders.

If you're keen to engage with IPOs and explore the potential they hold, consider markets.com, a platform where you can trade CFDs on the latest companies hitting the public markets.

“When considering initial public offering (IPO) for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.”