IPOs and what they are all about

IPOS present an exciting adventure into the world of risk for the avid investor and speculator alike. Often, the reward can be a large profit. Remember, every blue chip stock trading on the markets today was, at one time, an IPO. On the down side, consider too, all those share certificates cluttering dresser drawers or sitting in strong boxes of dusty attics, representing the dreams of investors who put money into companies that no one remembers.

An IPO is when a privately held company makes its first share offering to the public.

The shares which the company puts on the market are directly owned and issued by the company, so that when they are purchased by the public, the cash generated goes directly to the company.  As opposed to future trades of those shares on the market, in which case the cash transfers from one investor to another. The intent an IPO is to raise capital necessary to carry out some form of a corporate growth plan. Of course, you can readily see, the uncertainty in knowing what the stock will do once market trading begins.

IPOs are not always issued by small, start-ups or companies that are not much more than a great idea, though these are definitely most intriguing.  Many IPOs are issued from well established, well run, privately owned companies which for various reasons, find themselves in transition, and going public becomes a part of that change. These organizations come with an established financial track record which can be assessed and diagnosed before turning over your cash.

Historically, there was a time new ventures could just start up and issue stock to a willing public with unbridled restraint. Have an idea, a concept, just sell a piece of it.  That is often how IPOs used to take shape.  Obviously, that approach became a wide-open door to swindlers and was wrought with fraud. Up stepped various levels of government with legislation to protect its citizens, self-regulating industry agencies to enforce compliance, and watchdog organizations to monitor activities. Now-a-days the road to an Initial Public Offering is not an easy one. There are some stringent prerequisites to meet and sometimes tough ongoing regulations which must be adhered.  All this makes it easier for the investor to do his homework and reduce corporate deceit, but to be sure, there are still no guarantees.

For some companies, the cost can be a delaying or even prohibitive factor and for others it might be the amount of reporting  and required supporting documentation filings with the apporpriate security exchange commissions holding them back from an IPO.

Currently in the news, one well known US website, Classmates.com which is a popular social networking site in existence for quite some time, had complied with all the required procedure, and only days before their IPO date, withdrew. The downturn in the economy was the main reason behind the decision. Estimates give the cost of the Classmates.com withdrawal to be somewhere between $4.5 and $5.4 million in direct costs paid to underwriters, lawyers, accountants, and listing fees.

In Canada, the process of selling shares to the public for the first time is only slightly less complicated and less expensive. There were 90 IPO’s which made it all the way to the TSX and TSX Venture exchanges in 2007. The combined value of the equity raised by these issues was $3.4 billion. That is much less activity than the norm over the past decade. By comparison, 109 new issues worth $5.6 billion made their way on to those markets in 2006. {mospagebreak}

Getting an IPO off the ground

The Prospectus

Once a company has decided they have a marketable offering capable of raising the funding they are after, the first order of business is to prepare a prospectus. A prospectus is a lengthy, detailed document which, by law must accompany any direct company-to-consumer offering of an investment opportunity. The nicely printed booklets probably are best known to you as an accompaniment to a mutual fund sales pitch. The prospectus is a legal document that institutions and businesses use to describe the securities they are offering for participants and buyers. A prospectus commonly provides investors with material information such as a description of the company’s business, financial statements, biographies of officers and directors, detailed information about their compensation, any litigation that is taking place, a list of material properties and any other material information. In an IPO offering, a prospectus is distributed by underwriters or brokerages to potential investors.

Underwriting

Choosing an underwriter and coming to agreement with them is the next step when a company goes public. The main role of the underwriter is to get the stock on the street. They also provide considerable guidance to help meet exchange and security commission requirements, arrive at a correct “to market” price and number of shares to issue, and generally apply their experience to help guide a company through the new territory of going public. The underwriter actually takes over the management of the entire process.

The managing underwriters may underwrite the IPO on either a firm commitment or best efforts basis. In a firm commitment offering, the underwriters will purchase the shares at a discount (of usually 7%) and resell them for the full public offering price to institutional and individual investors. In contrast, a best efforts offering means that the underwriters are only committing their best efforts to sell the shares.

Most reputable investment banks will underwrite an IPO on a firm commitment basis. If an IPO is being underwritten on a best efforts basis, it should serve as a warning signal to both the company and its potential investors. After all, how enticing will a company’s shares appear if its investment bank is unwilling to shoulder the risk of holding the shares, especially when purchased at a discount?

To help distribute the shares, the managing underwriters may form a syndicate composed of other investment banks. This serves two purposes. First, the underwriters may expand the marketing of the company’s shares through other investment banks. Second, the managing underwriters may reduce their risks by allocating shares to other investment banks. The syndicate members may agree to participate by either purchasing and reselling the shares, or just marketing the shares to their institutional and individual clients.{mospagebreak}

Filing with the Security Commission

To protect investors, the Securities and Exchange Commission (the SEC) requires that companies file a registration statement with them before they issue public offering shares. This registration statement contains detailed information about the issuing company and its business. The Securities Exchange Commission will review the registration statement and an accompanying prospectus to ensure that they conform to certain legal requirements. Once the SEC has reviewed these documents, the issue can be cleared for sale. (The SEC will neither approve nor disapprove an issue, nor will it guarantee the accuracy of disclosures; it will only clear it for sale.) Only when the issue has been cleared for sale (when registration has become “effective”) can the shares be priced and firm orders for them are accepted. The SEC is part of the US procedure, but the process in Canada is very similar. One snag Canadian business would like to see changed is a move to a more uniform system such as the US has deployed. Presently, provincial legislation governs securities and the premier jurisdiction is the Ontario Securities Commission (the SEC equivalent) which administers and enforces the legislation. Ontario is home to the TSX and TSX Venture markets so most IPOS go through the Ontario Securities Commission to gain approval. Thanks mainly to mining stocks and the Vancouver Exchange, British Columbia is also a very active jurisdiction.

The guideline most companies follow is to conform to SEC requirements because they may one day wish to trade on a US market, and in so doing, the stringent US filings will meet or surpass most Canadian disclosure demands.{mospagebreak}

Stock market requirements

In Canada, we have only two “boards” where a company can list their shares for public sale, the TSX and TSX Venture. They are distinguished by the market capitalization of the shares traded on each of their exchanges and other considerations. So after meeting all filings with the exchange commissions, the prospective IPO must file disclosure documentation which meets the approval of the exchange.

The “big board” or TSX has 500 or so fewer listings than the TSX Venture Exchange, but these account for a much greater daily volume than the 2100 Venture listings. It is the senior market, reserved for well established businesses with management teams having more experience in public markets. The TSX does have some micro cap companies (market capitalization under $50million), most are small cap (market capitalization over $50million but less than $500 million) and some medium and large cap. The TSX Venture Exchange offers companies a flexible, two-tiered system. The tiers have minimum listing requirements based on a company’s financial performance, resources and stage of development. The industry segments within each tier recognize the different financial and operating needs of companies operating in different industry sectors. Tier 1 is for senior companies with the most significant resources. Tier 2 issuers have fewer filing requirements.

 

The switch from institutional buyer to seller

Most attractive stock issues are taken up in large blocks from the underwriter by institutional buyers who might hold some of the stocks and put some on the market for individual buyers. The number of shares they will let go of depends upon the movement of the shares in the market. Remember, just like you, institutional sellers are looking to make the best possible profit from an issue they have purchased at a most attractive price point.{mospagebreak}

Excerpts from the following Canadian Press article on the Tim Horton IPO in March of 2006 is an interesting and thorough account of what can happen:

Tim Hortons Inc.’s initial public offering last week had investors clamouring for a piece of the action, but most were left sipping their double doubles from the sidelines.

Those lucky enough to receive shares at the IPO price of $27 could have sold minutes after trading began Friday morning for a 40 per cent return.

In fact, if you had obtained shares in each of this year’s 41 initial public offerings registered in the United States by the beginning of this week, your average return so far would be 19 per cent, according to Greenwich, Conn.-based Renaissance Capital, a research and investment firm that specializes in IPOs.

That compares to a gain of about 7.2 per cent on the TSX Composite Index over the same time frame.
“The average investor should be wary of IPOs,” especially on this side of the border, cautions Norman Levine, managing director of Toronto-based Portfolio Management Corp.

“Tim Hortons is an anomaly,” he says. “Most IPOs in Canada do not go to quick premiums. Buying IPOs for quick flips in Canada is generally a losing proposition.”

In the United States, investment banks tend to set lower initial public offering prices, leaving the buyer with higher potential gains, Levine says. “But in Canada, they seem more interested in getting the highest price for the issuer, which works against the buyer.”

“Companies in the U.S. seem to want to leave more on the table for their investors, to make them happy, whereas in Canada, the thinking of the investment banks is to give the maximum amount to their client – being the issuer – and not worry about the buyer on the other end,” Levine says.

The “Wall Street system benefits large institutional investors who have relationships with every major underwriter.”

“Institutional investors get the information necessary to make informed decisions: underwriters (send) overnight prospectuses to their doorsteps and invite them to the road show lunch at which the IPO’s management team explains the company’s strategy.

In Tim Hortons’ case, Levine said that the lead underwriters – RBC in Canada, and Goldman Sachs in the U.S. – sold the shares at the IPO price to their good clients, like pension funds.

“It’s a gift,” he said.{mospagebreak}

There is a sizeable group of investors who concentrate their investment efforts toward following upcoming IPOS. They love the excitement and the prospects. As we have seen earlier, most of the good opportunities are gobbled up by investors having the rail position. Speculators can still get in on early trading and satisfy their appetite.

The TSX Venture Market in Canada and the Over The Counter Bulletin Board Market in the US is almost totally ignored by the institutional buyers and their security blanket clients. Canada and the TSX-V happens to be a world favourite opportunity for speculating in mining stocks. It is a penny stock haven where, untouched by inflation, penny stocks are still a penny stock. The IPOS in this market are of interest to individual investors because individual investors are the life blood of the issuing companies. They are out to woe you and convince you any way they can within the framework and governance of the securities commission system.   For speculators herein lies the excitement.