Behind The Big Numbers

You certainly heard about Saudi Arabia’s plans to sell a stake of its state oil company Saudi Aramco.

Technically, the sale of Aramco would be less than 5% of the company and via an initial public offering (IPO).

A 5% listing on the stock market would give it a potential value of over 100 billion USD. It’s gonna be the largest IPO in financial history, since even conservative estimates of Aramco’s value are in the 2 – 2,5 trillion USD range. That’s about 15 times the GDP of Romania. Big numbers, indeed.

I’m always skeptical about big announcements, but honestly I have no clue, whether the plan of the Saudis will be successful.

However, based on a little office-internal survey, I have a pretty clear idea, that 9 out of 10 Romanians don’t really know what an IPO is and how it gets done – that’s why today’s post is explaining the process of an IPO where a company issues stock to the public for the first time.

Why would a company want to go public in the first place?

  • To raise money to grow the company. This is the most common reason.
  • The company may have private equity investors who want to exit from their investment. It may have senior management that may be retiring or seeking to monetize their investment. It may want to reward employees with options.
  • Balance sheet restructuring; they are raising money to pay down debt.
  • Acquisitions: they need money to buy other companies.

The first step is done about 6 months prior to the IPO and it’s called ‘beauty contest’. The IPO-candidate is looking for investment bankers like Morgan Stanley, Goldman Sachs, Deutsche Bank or Credit Suisse. The banker writes the legal documents and leads the company through the IPO process. The banker will ‘underwrite’ the deal—that is, they will buy up all the initial shares and then sell them to the public at a predetermined price.

A company like Aramco will have each and every investment bank from New York to Tokyo competing for the IPO-deal. The fees are juicy. For a small IPO (about 100 million USD) it could be as high as 6 to 7% of the float. Generally the bigger the IPO, the smaller the percentage fee. Larger IPO’s generated fees of 3-5% recently, but in Aramco’s case it would be probably much lower, maybe 1, max 2%. Still, fees of over 1 billion USD are in play for investment banks.

Once the underwriting team of bankers (plus lawyers and accountants) is defined, the IPO work starts based on regulatory requirements of the stock market, the company plans to use for the IPO.

Since Aramco is the biggest IPO ever, chances are, they will float their shares at the biggest stock market, the New York Stock Exchange (NYSE). The regulator of the NYSE is the Securities and Exchange Commission (SEC). And first of all, the SEC requires the S-1 document.

The S-1 document (in most cases confidential) is to be submitted about 3 months prior to the IPO and reveals all about the company: the plans for its proceeds, its business model, the competition and its corporate governance, risks, and executive compensation. The SEC wants as much transparency as possible to make sure investors have enough information to make investment decisions.

Once the SEC approves the document, and they are satisfied there have been sufficient information and disclosures, the company can file a ‘public’ S-1 for investors.

Three weeks after the public S-1 is filed, the company is allowed to launch a ‘road show’, a global tour to meet potential investors. At the start of the road show, terms for prize and size of the IPO are announced. The company will say they are seeking to sell 100 million shares between 20 and 23 USD for instance.

How do they determine the price and size? Typically bankers will look at several metrics, including the present value of a company’s cash flow, the value of the company in relation to sales or cash flow, or the value of comparable competitors who are already publicly traded.

The road show is a critical step in the IPO process. What investors attend a road show? The whole spectrum: Hedge funds, mutual funds, banks, pension funds, endowment, and individuals. In the process of the Alibaba-IPO in 2014 there were two separate teams on the road show around the world. Over 900 investors showed up at the road show in New York.

During this process the company is also getting feedback from investors on demand for the stock. The bankers will be building a book of offers to buy the stock at various prices, and depending upon the demand they will adjust the price and the number of shares they are going to offer. Investors usually put in a request for more shares than they really want, because most do not get a full allocation.

At end of the road show, 1 day before the IPO, the orders are all consolidated, the bankers will announce a final price and deal size. Investors who put in bids to buy the stock will find out how much they were able to buy, assuming the price was acceptable to them.

The day after the stock is priced, the company goes public. Let’s say the company has decided to sell 100 million shares at 20 USD. The bankers have bought up those shares and have sold them to investors at that price. Most IPOs also give the underwriter the right to sell an additional 15% more (called ‘greenshoe-option’) if there is sufficient demand.

But that doesn’t mean the stock will open at 20 USD. The opening price will be determined by the demand on the part of all the investors who didn’t get stock but want it, as well as by investors who got stock but want more.

Bankers typically like to set the IPO price just high enough to have it open modestly on the upside. Many aim to have the price up 10 to 15 % on the first day. That’s generally considered to be a “successful” IPO.


16 Sept 2014 – Thumbs up: Alibaba founder Jack Ma as he arrives to speak to investors at a road show in Singapore 3 days prior to Alibaba’s IPO in New York.

Alibaba IPO

19 Sept 2014 – Bang! Alibaba began trading on the New York Stock Exchange, soaring 38 percent per share.

Initial Public Offering

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