*All Authors are from Cornell University, Johnson Graduate School of Management, Cornell University Ithaca NY 14853. Michaely is also affiliated with Tel-Aviv University.
A Guide to the Initial Public Offering Process
A milestone for any company is the issuance of publicly traded stock. While the motivations for an initial public offering are straightforward, the mechanism for doing so is complex. In this paper, we outline the process by which companies are brought to market in an initial public offering. Our goals here are to delineate the specific steps that are required in an IPO, to demonstrate the complex inter-relationships between the advising, marketing, pricing, and trading functions of the IPO process, and to highlight the role played by the underwriter in a public offering.
When a company wishes to make a public offering, its first step is to select an investment bank to advise it and to perform underwriting functions in connection with the issue. The selection process relies on the investment banker’s general reputation and expertise as well as on the quality of its research coverage in the company’s specific industry. The selection also depends on whether the issuer would like to see its securities held more by individuals or by institutional investors (i.e., the investment bank’s distribution expertise). Prior banking relationships the issuer and members of its board (especially the venture capitalists) have with specific firms in the investment banking community also influence the selection outcome. Often, the selection process is a two-way affair, with the reputable investment banker choosing its clients at least as carefully as the company should choose the investment banker.
The most common type of underwriting arrangement involved with large issues is the “firm commitment” underwriting. In a firm commitment underwriting, the underwriter purchases the entire issue of securities from the issuer and then attempts to resell the
securities to the public. The difference between the price at which the underwriter buys and subsequently sells the issue is called the gross spread. Public offerings can be managed by one underwriter (sole managed) or by multiple mangers. When there are multiple managers, one investment bank is selected as the lead or book-running manager. The lead manager almost always appears on the left of the cover of the prospectus, and it plays the major role throughout the transaction. The managing underwriter makes all the arrangements with the issuer, establishes the schedule of the issue, and has the primary responsibility for the due diligence process, pricing and distribution of the stock. The lead manager is also responsible for assembling a group of underwriters (the syndicate) to assist in the sale of the shares to the public. Members of the syndicate are paid a portion of the gross spread for their participation. The lead underwriter, the co-managers and the syndicate members all receive compensation from the company for being involved in the IPO process. This compensation comes from the gross spread—the difference between the price the securities are bought from the issuer, and the price for which they are delivered to the public. The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread. The second portion of the spread is called the “selling concession”, and it is the amount paid to the underwriter and other syndicate members for actually selling the securities. This is typically equal to 60% of the gross spread. Each syndicate member receives a selling concession based on the amount of the issue it sells to its customers. Institutions occasionally directly designate the selling concession credit associated with their stock purchase to a specific syndicate member...