Startup companies and IPO

A start up is a new entrepreneurial idea turned into a business venture, a company or partnership with the main purpose of being profitable by creating a repeatable and scalable business model. Startups can have huge money making potentials, or they could end up being failures. Investment in start-ups is considerably risky; take for example the dot com bubble in the late 1990’s.

There was an investment frenzy, many had projected boom in the stock of internet related start-ups only for most internet related start-ups to come crumbling down because of lack of  sustainable revenue; a major oversight in their business plan. However internet start-ups such as Amazon and EBay were able to stand the test of time, while also becoming the 2 biggest giants in the e commerce industry.

Startups are initially financed by the entrepreneur who conceived the business idea; but as the startup grows, the financing of the entrepreneur may prove inadequate. The start-up could either seek finance from a venture capitalist or go into the equities market for finance with an initial public offering. A venture capitalist is an investor who supports the growth of a start-up by providing capital or undertaking any other activity that would support the growth of the business. An initial public offering is offering the stock of a privately held company to the public for the first time. It marks the transition from private company with few owners to a public company which virtually any body can own. In order for a company to go public, the company must prepare a prospectus which must be approved by the Securities and Exchange Commission. After approval, the company is free to solicit investors to buy the shares it would offer.

In most IPO’s, a company hires the services of an investment bank. The investment bank underwrites the IPO which may serve as a risk to the investment bank. This is because the company sells the shares effectively to the investment bank, and then the investment banks sells to various groups.  The high risk is due to the fact that if the investment bank is unable to sell all the shares, they become responsible for any portion of the offering that failed to sell; they may even end up making a loss on the deal.

Aside the underwriting, we also have the best effort, whereby the underwriter promises to get the shares in the hands of investors but is not responsible for any portion of the offering that failed to sell. In an underwriting, the investment bank’s pre concern is to look for enough investors to sell out the shares. Because of this pre concern, before taking up an underwriting, investment banks contact specific investors who are known to invest heavily or with large investment capabilities; these investors include pension funds, endowments, mutual funds, insurance companies and hedge funds.

The bank carries out a survey to find out the range of prices and possible investment commitments of institutional investors; this is called book building. Institutional investors usually under bid IPO’s to pull the price down and profit on undervalued shares when the company goes public.

Knowing that the IPO is undervalued, investors try to buy the IPO on the first day of trading, thereby raising the price; after a while, reality dawns on investors, and they ask if the shares is actually what the price.  A period of under performance of the shares then follows; it is known as subsequent under performance.

Recommended Reading 

Steven M. Bragg., Running a public company: From IPO to SEC Reporting