What is a Hot IPO?
A hot IPO (Initial Public Offering) is the first-time issuance of a company’s shares to the general public in an open market. One or more investment banks can act as underwriters for the hot IPO arrangement. The essence of issuing shares through hot IPO markets is to raise a substantial amount of money for the issuer’s growth and offer an exit-route for the existing shareholders.
Companies can also go public using other methods other than IPO, such as direct public offering and direct listing. Hot IPO involves a step-by-step process facilitated by lead underwriters and can take months or years to complete.
- A hot IPO is issued by a closely-held company to the general public who are interested in making lucrative trade with the offerings.
- A private company can initiate a hot IPO to acquire working capital for its future growth and expansion.
- Hot IPOs may lead to oversubscription of investors in which prices shoot up immediately after trading starts.
Understanding Hot IPOs
When a company is formed, it is first owned by a single person or a group of people. At that point, it is called a closely held or private company. One of the ways that such a company can raise capital is to sell shares of stock to the public in a process colloquially known as “going public.” The issuance attracts public attention and increases brand visibility, hence the name hot IPO.
Usually, a selected investment bank is involved in analyzing the prospects for a successful initial public offering of the company’s shares. The investment bank or a group of investment banks may then agree to act as underwriters for the proposed IPO and arrange for the shares to be listed on a single or several stock exchanges. A portion of the sales proceeds from the IPO is treated as an underwriter’s fee.
As the company transitions from a private company to a public company, investors are able to trade the company’s shares freely, and the company must now comply with a multitude of regulations requiring consistent public disclosure of vital information to potential investors and existing shareholders.
Reasons for Launching Hot IPOs
Companies launch an IPO to raise new equity capital in a short time and enable early investors to cash out. The public demand for its shares enables closely held companies to cash in for their holdings.
The formal process to produce HIPO in a hot market is well structured and disclosed to the potential purchasers using a prospectus. However, the process of setting up an IPO process is marred with regulatory hurdles. Most of the companies that roll out the IPO process are young, small, and risky; hence their success or failure highly depends on the aftermarket performance.
The money raised by the offerings goes direct to the company or is used to pay earlier investors. It means that other than soliciting for working capital, a company goes public to repay the debt it owes its earlier investors.
The Underwriting Process
There are five distinct steps involved in the IPO process. Generally, a company that plans to issue its shares must coordinate with one or a group of underwriters. The process is explained in the following steps:
- The issuer selects an underwriter or a group of underwriters and negotiates an agreement.
- The issuer works alongside the underwriter to draft a prospectus and register the offering to the U.S. Securities and Exchange Commission (SEC).
- The underwriter then stages roadshows to introduce the offering and its management to potential investors.
- The underwriter determines the offering’s final price after the SEC authorizes it.
- The lock-up period follows after the start of the trading, where institutional investors are not allowed to sell their holdings on the open market to prevent a potential run on the stock and price destabilization.
Preparing to issue stock via an IPO requires substantial planning. Some of the underlying issues that must be addressed include corporate planning, executive compensation, corporate charter and bylaws, and corporate structure.
In most cases, issuers will go for prestigious investment banks with a network of institutional investors. It is because such institutions are knowledgeable about the issuer’s business and will continually monitor and maintain a market interest for the company that plans to sell shares on public stock exchanges.
Oversubscribed and Hot IPOs
Usually, investors attracted to hot IPO expect the demand for publicly-traded shares to exceed their supply. Offerings with more demand than the number of shares offered are regarded as oversubscribed shares. Such types of IPOs appeal to investors who hold equity for long-term benefits.
Furthermore, there are trading price run-ups during the first day of trading due to increased demand for the shares. Companies use the phenomenon to increase their offerings in order to accommodate more investors to cash in more.
The success of an underwriting depends on three variables – the size of the IPO, trading price, and the amount of interest in the shares. The alignment, when correctly done, maximizes profit for both the investment bankers and the issuer.
An underpriced IPO will experience a price increase after the shares hit the market, and eventually, the market adjusts to the overwhelming demand. However, the underwriter cannot just align demand and supply by simply issuing and distributing more shares since the registration statement contains a fixed number of shares to be distributed.
Instead, an underpriced IPO relative to market demand will undergo a sharp rise in the price soon after the stock begins trading. It is the sharp rise in trading price that makes an IPO “hot.”
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)™ certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: