An initial public offering (IPO) is the first sale of a corporation's common shares to public investors. The main purpose of an IPO is to raise capital for the corporation. While IPOs are effective at raising capital, they also impose heavy legal compliance and reporting requirements. The term only refers to the first public issuance of a company's shares; any later public issuance of shares is referred to as a Secondary Market Offering. A shareholder selling its existing (not new) shares to public on the Primary Market is an Offer for Sale.
IPOs generally involve one or more investment banks as "underwriters." The company offering its shares, called the "issuer," enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.
The sale of shares in an IPO may take several forms. Common methods include:
- Dutch auction
- Firm commitment
- Best efforts
- Bought deal
- Self Distribution of Stock
A large IPO is usually underwritten by a "syndicate" of investment banks led by one or two major investment banks (lead underwriter). Upon selling the shares, the underwriters keep a commission based on a percentage of the value of the shares they sell. Usually, the lead underwriters, i.e. the underwriters selling the largest proportions of the IPO, take the highest commissions—up to 8% in some cases.
Historically, IPOs both globally and in the US have been underpriced. The effect of underpricing an IPO is to generate additional interest in the stock when it first becomes publicly traded. This leads to massive gains for investors who enter the IPO early. However, underpricing an IPO results in "money left on the table," lost capital that could have been raised for the company had the stock been offered at a higher price.
Investment banks therefore take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company.