U.S. Markets close in 2 hrs 52 mins

How Does an Initial Public Offering Actually Work?

The initial public offering market was an interesting one to watch in 2019. Some public offerings, like those carried out by Lyft (NASDAQ:LYFT) and Uber (NYSE:UBER), were widely perceived to have flopped, while others, such as Beyond Meat (NASDAQ:BYND), surprised investors. One widely-publicized IPO, WeWork, didn't even manage to get off the ground. Have you ever wondered how the IPO process actually works?

Why would a company want to do an IPO?

Let's start by asking ourselves: why would a company want to do an IPO in the first place? The short answer to this question is because they need money. Traditionally, when a company grows past a certain level and it becomes difficult to raise equity from private investors, the business in question must turn to the public markets and list on a stock exchange in order to sell securities to buyers in the open market rather than having to negotiate directly with private buyers.

Nowadays, there is a lot more private money available to companies, with private equity groups like Blackstone, Carlyle and others being more than willing to provide money to businesses. Indeed, this is one of the reasons why companies like Uber, Lyft and WeWork could get as big as they did without having to turn to the public market. There are many advantages to the PE model, not least of which is that private companies do not have to disclose nearly as much information as public companies.

Additionally - and this is a more controversial point - it has been argued that the IPO is now being used primarily as a way for founders and early backers to sell their equity to the public as inflated valuations rather than as a way for businesses to raise capital (of course, they might be doing it for both of these reasons).

Who else is involved?

Regardless of why the business is doing an IPO, it needs the help of an underwriter to do this. Typically, this role is played by an investment bank which guarantees the proceeds of the IPO to the issuing business, thereby taking on the risk of the process. Additionally, the underwriter is responsible for marketing the IPO to potential investors, setting the price of the offering, and carrying out other regulatory duties.

What's in it for the underwriter? By guaranteeing a minimum price to the issuing company, and being able to charge whatever price they want in the public market, the underwriter is able to pocket what is known as the underwriter spread (the difference between the two amounts) as a fee.

Should value investors buy shares issued in an IPO?

All of this creates an interesting conundrum for the value investor. Presumably, the issuing company will not agree to a guaranteed amount that is less than the intrinsic value of the business (which they are in the best position to assess). Therefore, whatever price the shares debut at must necessarily be higher than the intrinsic value of the business, as that number needs to include the investment bank's spread. Therefore, it makes little sense for a value investor to buy into an IPO, which, incidentally, is why Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) hasn't ever bought a new issue.

Disclosure: The author owns no stocks mentioned.

Read more here:

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.