· What is an IPO?

An initial public offering (IPO) is the process through which a company makes the transition from a privately held entity to a public company with stock traded on one of the major stock exchanges. Typically, a company going through an IPO is young and relatively unknown, therefore IPOs generally are considered riskier investments. However, established private companies occasionally decide to "go public" in order to raise more capital.

· The underwriter

The issuing company (i.e., the company going public) needs the assistance of an investment bank -- referred to as the "underwriter" -- to price and market its stock offering. Banks compete for the issuing company's business during a process known as the "beauty contest" or "bake-off," in which they present their credentials to the company's board of directors and assess a preliminary valuation of the company. If the issuing company is new and relatively unknown, the banks often make valuations based on the company's competitors.

The issuing company generally chooses an investment bank based on its underwriting experience, particularly with IPOs in the same industry. Another consideration for the issuing company is the credibility of the investment bank's research analyst, who issues reports on the company throughout the year.

The issuing company can give its business to more than one underwriter, in which case the bank that manages the IPO becomes known as the "lead underwriter," and the group of banks participating in the deal are called the "syndicate."

· The prospectus

The Securities Act of 1933 requires a company intending to go public to file a legal document known as the "prospectus" with the Securities and Exchange Commission (SEC). The prospectus includes the company's financial history and growth strategy, the details of its offering, and information on company management. It also outlines industry competition and other risk factors that investors would want to know in advance. In essence, the prospectus provides all of the information investors need to know in order to decide whether to participate in the IPO. The preliminary prospectus is also known as a "red herring" because of the red ink used on the front page, which indicates that some information -- including the price and size of the offering -- is subject to change.

· For more information on how to read a prospectus, see "A look at the prospectus" by Darren Chervitz of CBS Marketwatch.

· The "road show"

An essential part of the issuing company's marketing campaign, the "road show" is a multi-city tour during which the company pitches its business plan to potential investors, usually institutional investors such as mutual funds, endowments, or pension funds. At these meetings, the underwriter attempts to gauge the level of interest in the IPO, which helps lead to a decision on how to price the stock offering. Typical stops on the tour include New York, San Francisco, Chicago, Los Angeles, and Boston. If the underwriter senses enough international interest, a road show also may visit Europe and Asia. Following the road show, the company prints its final prospectus, distributes it to potential investors, and files it with the SEC.

· Pricing and allocating the IPO

During and after the road show, in a process known as "book-building," the lead underwriter surveys potential investors and notes the interest in the stock so it can price the IPO accordingly. The issuing company and the lead underwriter meet to set the "offering price" and the number of shares to be issued at the offering, based on the expected demand for the stock.

For the investment bank, the objective is to balance the company's desire to price the stock so as to raise as much money as possible and the investors' interest in gaining some financial reward for taking on the risk of investing in a company with an unproven public track record. Each bank in the syndicate receives a certain number of shares to allocate to its clients.

· The "pop" versus "money left on the table"

The "pop," also referred to as the first-day price spike, is the price differential between the offering price of an IPO stock and its closing price on the first day of trading. During the dotcom bull market of the late 1990s, with first-day gains reaching triple-digit percentages, the pop unofficially became an important marketing or "branding" event for the issuing company.

The pop multiplied by the number of shares sold is known as the "money left on the table" -- that is, money in the hands of investors rather than in the issuing company's coffers. In order to balance the needs of the investor and the issuing company the investment bank traditionally tries to price a deal so that the first-day pop is about 15 percent. Thus, the issuing company can raise substantial capital while investors are rewarded for gambling on a riskier investment.

· "Flipping" the stock

The practice of an investor buying stock in an IPO at the offering price and quickly selling it for a profit when it starts trading is known as "flipping." Though it became common during the dotcom IPO frenzy of the late 1990s, this practice is generally discouraged by underwriters, who are looking for investors willing to make a long-term commitment to the company. Such anti-flipping policies, however, do not apply to large institutional clients of investment banks.

· The "quiet period"

The quiet period begins when a company files a preliminary prospectus with the SEC and ends usually 25 days after the stock starts trading. During this period the company is prohibited by the SEC from distributing any information about the company not included in the prospectus.

· The "lockup period"

The lockup period is the period during which company insiders -- primarily management and venture-capital investors -- are prohibited from selling their shares. U.S. law mandates that the lockup period last for 90 days after the stock is first publicly traded, although this period is often extended to 180 days to satisfy potential investors.

· Can individuals invest in an IPO?

Underwriters typically allot IPO shares to their best clients, including hedge funds, large institutional investors, and some wealthy individuals. Therefore, shares are difficult -- though not impossible -- for the average individual investor to obtain. The best advice for an individual seeking to invest in IPOs is to develop a relationship with a broker who can obtain IPO allocations for his or her clients.

Online investment banks are another option for individual investors seeking IPO shares. Several online investment banks, such as Soundview Technology Group (formerly known as Wit Capital), E*Trade, or W. R Hambrecht & Co. offer IPO shares directly to retail customers. Charles Schwab also offers IPO shares to retail clients who meet certain eligibility requirements.

· For more, see "Getting a Piece of the Action," by the editors of CNN and Money magazine.

SOURCES