The ABCs of IPOs

Feb. 20, 2001 -- Where do stocks get their beginning?

The proverbial longest journey starts with the smallest step, and so let's begin there, right at the beginning. A stock gets its start from the IPO, or initial public offering.

Simply, IPOs are the way in which privately held companies sell shares of their stock to the public for listing on an exchange. This process or event is what's known as "going public." While there are a good number of reasons why this is done, by far the most common one is to raise capital for the company's coffers.

Basically, IPOs can be divided into two categories: those that are self-underwritten, that is, where the company itself markets its securities without the assistance of an investment bank, and those that are underwritten by an investment bank or a group of investment banks, also known as a syndicate.

Now, I can't say with absolute certainty that there has never been a self-underwritten IPO that went on to become a highly valued and successful stock.

But I can say that out of the 6,000 or so IPOs that I have bought, sold, written about, watched or otherwise been made aware of over the course of my career, I'm unable to recall a single self-underwritten deal that made money for investors. Again, it could be that they exist and I just don't know of any. Having said that, it would be safe for you to assume that anything I say from this point on will be in reference to underwritten IPOs only.

Placing the Deal

OK, to further narrow our topic you need to know that there are two basic types of underwritten IPOs: best efforts offerings and firm commitment offerings. In a best efforts IPO, sometimes referred to as a mini-maxi deal, the underwriter sets forth a minimum number and a maximum number of shares that will be sold.

The underwriter will then use its "best efforts" to place the deal, but is not obligated to do so according to the underwriting agreement it signs with the company looking to go public. Without the minimum number of shares placed, these deals can simply be canceled.

There are problems, I think, with this approach to underwriting and therefore I avoid such deals on all fronts. I've never purchased a mini-maxi deal and I've never carried an opinion or even a record of one in my database. I don't see that changing any time soon, so you're unlikely to see any reference to best efforts deals in my columns or on the ipoPros Web site.

And now you could be asking, "Who are these underwriters and what role do they play?" The term "underwriters" refers to a team of specialists made up of investment bankers, market analysts, marketing people and salespeople who construct the actual deal and then sell it to investors. The role of the underwriters is fairly complex, but, simply put, it is to price the stock being sold and find appropriate buyers for these shares.

Extremely Competitive Business

There are a large number — probably hundreds — of underwriting firms out there. It might surprise you to know that perhaps only about 10 percent of these firms do upwards of 90 percent of the equity underwritings in this country.

From this statement you can surmise that the business of underwriting new issue stocks is extremely competitive. It would also be fair to say that the best deals — those with the greatest market valuation potential — almost always go to the top underwriters as clients. This is most likely a function of the clients seeking out those underwriters with the strongest reputations. It may also be due to the most successful underwriters aggressively marketing their services.

At the other end of the spectrum, those underwriting firms with less-than-sterling reputations or those that are young and do not yet have the marketing resources or muscle to attract high-quality clients, are left to scrap over smaller deals with less potential. As you can guess, rising up through the ranks of underwriters is difficult at best and requires a special mix of talent and luck. Rising into the top tier of players can take a century.

The next question you'll ask, or maybe it was your first question, is, "How do I participate in an IPO?" This is always the simplest question to answer, but the answer is almost always difficult to accept. Here's the simple part.

To buy an IPO an investor must place what's known as an indication of interest with one of the underwriting brokerage firms. This may be with the primary underwriter, known as the lead manager, or it may be with one of the other participating firms, referred to as syndicate members or selling group members.

The important thing to know here is that the lead manager controls all allocations of deal stock and is therefore the best place to get stock in an IPO. Easy, right? You just call up the lead manager and tell whoever answers the phone how many shares you'd like. Not so fast, cowboy. Here's where the trail gets rough.

Come back Thursday for part 2 of this series on IPOs.