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First Steps: Step One - From Private to Public

Understanding how the market works from the ground up is essential knowledge for all types of investors. This article looks at the process involved in taking a private company, and listing it on the stock exchange. It also explains how shares are offered to investors through what is called an "Initial Public Offering" or IPO.

Why would a company choose to list on the stock exchange in the first place?

The most obvious answer, and the most common reason, is to raise a large amount of cash in order to expand an existing business.

From the point of view of a private company, this is certainly almost always the case, although there are other reasons that have become increasingly prevalent over recent years. The most striking of these is to create a huge amount of wealth for the individual shareholders of the private company.

During the bullish market conditions of the late 1990s it was common for investors and business owners to use the listing process as a way to get cash for their investments.

Individuals who had the ability and timing to make investments in soon-to-be-listed companies generated millions of dollars. Many examples of this process can be found in the so-called "tech boom", which began in the second half of the 1990s. During the boom first day profits, upwards of 1000%, were not uncommon for some high profile technology listings. Locally, in New Zealand, there were also individuals who made large profits from short-term investments that happened to incorporate the listing process.

Despite the wealth generating capacity of the listing process, there are several serious implications of becoming publicly listed that a private company must consider. A stock exchange (a place where people can "exchange stocks" by buying and selling) controls the conditions under which a private company can list. These rules and conditions are aimed at protecting shareholders and investors and are usually enforced by a regulatory group controlled by the exchange itself.

Most stock exchanges around the world have similar listing rules and requirements, although there are often subtle differences based around minimum company values and some trading rules. In New Zealand, the New Zealand Stock Exchange (NZX Ltd) controls the listing rules. You can view the rules in detail on their web-site at www.nzx.co.nz.

The most important requirement, especially for individual shareholders, is something called "full disclosure".

Essentially this rule is aimed at making sure anyone who has an interest in buying or selling shares in a particular company is kept fully informed about what the company is doing. In other words, directors and managers of a public company must ensure that any information that cannot be kept confidential, and that might influence the price of the companies shares, must be made immediately publicly available to the whole market.

You can imagine the unfair advantage that a company executive would have if they could buy or sell shares based upon information that was not available to every investor. This is commonly termed "insider trading" and there have been several well-publicised examples in New Zealand over recent years.

Other stock exchange rules include governance principles, which state that company directors must always act in the best interest of the company and the shareholders. Financial disclosure and reporting is a clear requirement, and all business transactions must be publicly available to shareholders. Major decisions must be put to shareholder vote and detailed rules exist to restrict the issuing and distribution of additional shares.

As you can see there are many reasons why listing a company on the stock exchange might be more trouble than it is worth. Being responsible to thousands of shareholders and being required to constantly disclose your business activities can lead very large businesses to remain as private companies.

However to ensure there is investment opportunity and growth within an economy, it is beneficial for strong private companies to become publicly listed. The exact process that a private company must undergo is detailed and often expensive.

A private company that wishes to list must first undertake a process called "due diligence".

Due diligence means analysing and valuing the company and is usually performed by a professional accountancy firm. Following this, a value is assigned to the company and an appropriate number of shares are issued. If a company wanted to offer 10 million dollars worth of the company through a public offering then they might choose to offer 10 million shares each with a value of one dollar.

It is usually at this point in the process that the investing public is offered an opportunity to buy the shares. This is called the Initial Public Offering and is usually organised and promoted by a stock brokerage company.

When a broker undertakes this process they are said to "underwrite" the IPO. By underwriting the IPO, the broker is guaranteeing to the company that they will promote and sell all of the shares that are being offered. In return, the company that is listing pays the underwriting broker a commission for every share that is sold. For most brokers, this is one of their largest sources of revenue. Consider for a moment what this means for the individual investor.

When you are next offered the opportunity to purchase shares through an IPO, remember that the person or organisation selling you the shares will be paid a direct commission for selling them to you. It is essential that you take a careful look at the company you are investing in.

Most quality IPOs will be oversubscribed. This means that people are willing to buy more shares than are available for purchase. However sometimes IPOs are undersubscribed, which means there is not as much demand for the company's shares. When an IPO is undersubscribed it is worth considering why the demand is low.

Investing in a newly listed company through an IPO can be a good way to invest in a strong company from day one. However be aware that all IPOs are not created equal and that it can often be better to wait for the company to establish itself as a successful public company.

Summary

That was the first of a series of articles designed to increase your knowledge of the sharemarket. Next week we will explain how the modern day market was formed and how it functions on a day to day basis. Knowledge can make the difference between investment success and failure. We hope you enjoy each topic and move to becoming a more intelligent investor.

 

This article was written by Nick McCaw from Intelligent Investing

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