Primary Financial Markets and the Initial Public Offering

investing

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When you begin investing, it can be difficult to understand the complexity of financial markets. One important aspect to understand is how securities (stocks, bonds, etc.) are traded.

A capital market is where most long-term financial securities are bought and sold. Capital markets are classified as either primary or secondary, depending on whether securities are being created and sold directly to investors by the issuer (primary market) or resold among investors (secondary market).

Companies and government entities sell new stock and/or bond issues on the primary market to raise capital that can be used to fund business improvements or expand operations. The process of creating and offering new securities is very similar for stocks and bonds, although the most publicized transaction in the primary market is the initial public offering (IPO).

The IPO marks the first public sale of a company’s stock and results in the company being “publicly traded.”

The Initial Public Offering (IPO) Process – Going Public

When a company is first founded, the only shareholders are the founders. If the company needs to expand, it may issue more shares to other investors, diluting the existing ownership control. During this time, the company and its shares are considered private. In most cases, private shares are not easily exchanged.

If the company needs more investment capital than private investors can offer, or if the founders want to cash out and diversify their portfolio, the company can consider an initial public offering (IPO) where the company stock will be sold to the public. This process transforms the business into a publicly traded company.

When a company decides to go public, it first must obtain the approval of its current shareholders (the investors who own its privately issued stock). Next, the company’s legal team must certify that all financial disclosure documents for the company are legitimate and updated. The company then finds an investment bank willing to underwrite the offering. This bank is responsible for assisting with SEC registration, promoting the company’s stock, and facilitating the sale of the company’s shares.

Before offering its securities for public sale, the issuer must register with and obtain approval from the Securities and Exchange Commission (SEC). This federal regulatory agency must confirm both the adequacy and the accuracy of the information provided to potential investors. SEC approval requires that the company file a prospectus, which describes the key aspects of the securities to be issued, the issuer’s management, and the issuer’s financial position.

Once a firm files a prospectus with the SEC, a quiet period begins and the firm is limited on what it can communicate to investors. During this time, potential investors may receive a preliminary prospectus. This preliminary version is called a red herring because a notice printed in red on the front cover indicates the tentative nature of the offer. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company — that which is presented in the preliminary prospectus — but not to any unpublished information that might provide an unfair advantage. The quiet period ends when the SEC approves the details in the firm’s prospectus.

Putting on a Road Show

After SEC approval but before the official IPO date, the underwriting investment bank begins promoting the company’s stock offering through a road show, which consists of a series of presentations to potential investors (typically institutional investors) around the world. In addition to providing investors with information about the new issue, the road show helps the investment bank gauge the demand for the offering and set the expected price per share.

The main purpose of the investment bank during this process is to provide accurate underwriting. This involves purchasing the securities from the issuing firm at an agreed-on price and bearing the risk of reselling them to the public. Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, an investment bank may pay an issuing firm $20 for the stock that investors will ultimately purchase for $23.

In the case of large initial security offerings, the lead investment bank can invite other bankers to form an underwriting syndicate. The syndicate shares the financial risk associated with buying the entire offering from the issuer and reselling the new securities to the public. The lead investment bank and the syndicate members put together a selling group, normally made up of themselves and a large number of brokerage firms.

Selling the Shares

Setting the initial price per share is important for both the issuing company and the underwriting bank.

The issuing company is paid by the investment bank according to the underwriting process. If the issue price is too low, the IPO will sell out very quickly and price of the stock will rise on the secondary market. But because the issuing firm is only paid when the primary issue is sold to the investment bank, they will be unhappy because the issue price could have been higher. If this issue price is too high, the investment bank loses because they might have trouble selling the entire stock issue.

Once all of the issue terms and price have been set, the SEC must approve the offering before the IPO can officially take place. After approval, the IPO shares are then sold directly to investors.

Traditionally, almost all of the original issue shares go to institutional investors and other special groups targeted during the road show. Individual investors are typically unable to purchase shares at the original issue price and are forced to trade on the secondary markets. For this reason, IPOs usually represent a poor investment.

The exception to this rule is Motif Investing, who offers direct IPO investments to retail investors. I’m hopeful that other banks and brokerage firms will follow suit.

Final Thoughts

This process of creating and offering new securities is very similar for stocks and bonds. Most new corporate bond issues also require an investment bank to underwrite and assist the process.

The market for government bonds is established differently. Investors can purchase Treasury securities directly from the government at treasurydirect.gov, and there is no need for the detailed underwriting process described in this article.

Did this article help you better understand primary financial markets and initial public offerings? Please share with a comment below.

Editorial Disclaimer: The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author’s alone.

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