The Underwriting Process

Getting a piece of a hot IPO is very difficult. To understand why, we need to know how an IPO is done, a process known as underwriting.

When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required - it's just the way Wall Street and Bay Street work. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters (brokerage firms) as middlemen between companies and the investing public. In Canada, Desjardins and the major chartered banks are the biggest underwriters.

The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued, and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a "firm commitment," the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a "best efforts" agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue.

It is also common for the syndicate to use a selling group. Members of the selling group express their interest to the syndicate and have no guarantee that their request will be filled. Expressions of interest are subject to rejection or allotment, in whole or in part, and the right is reserved to close the subscription books at any time without notice by the lead of the issue

Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the provincial regulators. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used, and insider holdings. The regulator then requires a "cooling off period," in which they investigate and make sure all material information has been disclosed. Once the regulator approves the offering, a date (the effective date) is set when the stock will be offered to the public.

During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to build up interest for the issue. They go on a road show where the big institutional investors are courted. This time is also called the marketing period.

As the effective date approaches, the underwriter and company sit down and decide on the price. This isn't an easy decision: it depends on the company, the success of the road show, and most importantly, current market conditions (of course, it's in both parties' interest to get as much as possible).

Finally, the securities are sold on the stock market and the money is collected from investors.

A company that is already listed on an exchange can, for various reasons, issue more shares through another public offering. Since shares were already issued shares through an IPO, this procedure is referred to as a "secondary offering". It is also frequently referred to as a "new issue".

A company that distributes a secondary offering issues new shares that are added to those already in circulation. For the investor, this type of issue is accessible through the same mechanism as an IPO however the period in which one can place an expression of interest may be quite short. As the company in question is already listed, investors have several sources of information (internet site, news releases and the company's financial statements) to help them make an informed decision.