Initial public offerings
What are the most common structures used for IPOs in your jurisdiction, and what are the advantages and disadvantages of each?
A US initial public offering (IPO) involves the issuer’s distribution of shares to public investors through underwriters. Unlike IPOs in other jurisdictions, a US IPO may be completed without listing the company’s shares on a stock exchange – although most IPO companies list their shares at the time of their initial public distribution. An exchange‑listed IPO is advantageous, since it:
- can be sold to a much larger group of prospective investors;
- offers stockholders greater liquidity in post‑IPO trading; and
- affords investors the protection of corporate governance standards prescribed by the exchange rules.
Most US IPOs are distributed through a syndicate of investment banks in a firm commitment underwriting. Under this structure, underwriters – acting as principals – purchase shares from the company at a negotiated price net of the underwriting discount (approximately 7% of the price to the public) and then resell the shares to public investors at a price that reflects the amount of the discount. In a few IPOs, typically undertaken by smaller issuers, investment banks distribute shares on a ‘best efforts’ basis. Under this structure, the investment banks act as the company’s agents in soliciting investors, which purchase the shares from the company rather than the banks. The firm commitment structure offers advantages over the best efforts structure, including:
- wider market acceptance;
- better distribution; and
- greater transaction certainty for the issuer.
Procedure and timeframe
What is the procedure and typical timeframe for launching an IPO?
A US IPO has three principal stages.
During the first stage, called the ‘pre‑filing period’:
- the IPO issuer selects its underwriters;
- the underwriters begin their due diligence investigation of the issuer;
- the issuer, the underwriters and their respective advisers prepare the disclosure document to be used in the offering; and
- the issuer begins any corporate restructuring required for it to offer shares and operate as a public company.
This stage typically takes three to six months to complete.
The second stage, called the ‘waiting period’, begins when the issuer files the registration statement – which registers the IPO shares for public sale – with the SEC for review. During this stage:
- the issuer amends the registration statement in response to SEC comments;
- the underwriters complete their due diligence investigation; and
- the issuer finalises its corporate restructuring plans.
After the SEC completes its review of the registration statement, the company and the underwriters value the company to determine the IPO price range for the offering and then market the IPO in a series of road show meetings with prospective investors. This stage typically takes 90 to 120 days to complete, assuming that market conditions are receptive for marketing the offering once the legal preparations have been completed.
The third stage, called the ‘post‑effective period’, begins after the road show when the SEC permits the issuer to sell its shares to the public by declaring the registration statement to be effective. The issuer and the underwriters then agree on the IPO price and sign the underwriting agreement governing the underwriters’ purchase of shares from the issuer and the resale of the shares to the public. The closing of the IPO and issuance of the IPO shares typically occurs two trading days later.
This last stage is completed in approximately one week. In some IPOs, there may be one or more subsequent closings within 30 days for the sale of overallotment shares (to cover the underwriters’ short position), which can total up to 15% of the number of shares sold in the initial closing.
What due diligence is required and advised in the IPO process?
IPO due diligence is intensive and covers business, financial, accounting and legal matters. Such due diligence is required in the IPO process to protect the offering participants from legal liability for damages for deficient disclosure in the registration statement. All of the issuer’s directors, the issuer’s executive officers who sign the registration statement, the issuer’s auditor and the underwriters can be held liable for materially false or misleading disclosure, unless they can establish a due diligence defence. ‘Due diligence’ refers to a reasonable investigation that provides a basis for believing that the registration statement is not materially false or misleading. Although the issuer is strictly liable for any deficient disclosure – and therefore has no due diligence defence – effective due diligence also can protect the issuer from liability by ensuring the material accuracy and completeness of the disclosure provided to investors. The underwriters and their counsel organise and lead the IPO due diligence process.
Pricing and allocation
What rules and standards govern share pricing and allocation in the context of an IPO?
The preliminary IPO share price range used to market an IPO is determined by negotiations between the issuer and the underwriters based on:
- valuations of comparable public companies;
- other customary valuation methodologies; and
- an estimate of the strength of investor demand for the new share issue.
The issuer and the underwriters determine the final IPO price to the public based on investor orders for the IPO shares received during the road show. The negotiated discount at which the underwriters in a firm commitment IPO purchase shares from the issuer is typically 7% of the IPO price to the public, but can be less for IPOs in which:
- investor interest in the issuer is expected to be exceptionally strong;
- the offering amount is high; and
- competition by investment banks for an underwriting mandate is vigorous.
The Financial Industry Regulatory Authority (FINRA) – a securities self‑regulatory organisation – reviews proposed underwriting compensation to ensure that it meets FINRA standards of fairness and reasonableness.
The allocation of IPO shares to investors in a firm commitment underwriting is managed through agreements among the investment banks participating in the IPO syndicate. The underwriting account is grouped into brackets with different underwriting commitments. An underwriter’s placement in a particular bracket is determined by a variety of factors, including:
- business origination;
- distribution capability; and
- historical placement.
The book-running manager determines the allocation strategy for the offering or the form that the book of orders for IPO shares should take, in accordance with market conditions and in consultation with the issuer.