An initial public offering (IPO) is when a private company first offers stock to the public as it becomes a publicly traded company. These companies undergo IPOs to grow their business, and they need to raise capital to do so. IPOs are also a cost-efficient way to finance growth objectives. When companies sell shares to the public, they increase their equity. This improves the company’s debt to equity ratio, which will improve their ability to borrow funds if needed. IPOs can also improve and expand the company’s public image.
When a private company decides to list on the stock exchange, they assign an investment bank to act as the underwriter. The underwriter evaluates the value of the shares and sets an offer price. They need to establish a price that is low enough to attract interest but high enough to raise enough capital for the company. Investment banks will use their distributed network to sell these IPOs. These may include fund managers, insurance companies and other financial institutions. When the IPO is underwritten, the underwriter will be obligated to buy the remaining unsold shares.
This is a method an underwriter may use to assist them to decide what to price an IPO. They do this by building a book and from using their network to collect bids from different institutional investors on the price and the number of shares they want to take on. The underwriter will use the feedback from this group of small investors to set the offer price. Prior to book building, IPO’s were underpriced or overpriced. This process has therefore enable underwriters to set more appropriate prices.
Lauren Hua is a private client adviser at Fairmont Equities.
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