What is an IPO? - The Definitive New Zealand Guide

Updated 31 March 2021

When companies get to a certain size, and it makes sense for them to do so, they may list on a public stock exchange in what is known as an Initial Public Offering (IPO).

Why have we published a guide to IPOs?
Our view is that capital markets have never been more accessible to New Zealanders, but this brings a danger of inexperienced investors unknowingly buying shares in companies that possibly don't meet their long-term wealth creation goals. Many IPOs in New Zealand have ended in disaster - CBL and MOA are of two two recent examples. To help explain IPOs in detail, our guide covers:

• ​What is an IPO?
• Three Must-Know Facts to Help Understand How IPOs Work
• IPOs - Advantages and Disadvantages for any Company Listing on the Sharemarket
• Frequently Asked Questions

Background - The NZX and IPO History

• The National New Zealand Stock Exchange was first established in 1983, amalgamating several regional stock exchanges that originated in the gold rush of the 1860s.
• Since then, the NZX has listed hundreds of New Zealand companies and provided a platform for New Zealand companies to access further capital. 
• Some notable IPOs on the NZX have been Xero, TradeMe, Air New Zealand, Fletcher Building and Spark (originally listed as Telecom). 

An IPO is typically the first time a company allows its stock to be traded to the general public (in this case – "public" refers to ordinary New Zealanders). Companies will look to issue new stock, similar to how companies raise Series A/B/C funding. The key difference here is they are raising from public investors rather than private investors. In a Series A, there may be two or three VC firms that "lead" a round, whereas in an IPO, there will be many smaller investors looking to get a piece of the IPO alongside institutional investors. Recent examples include thousands of New Zealanders buying shares during the IPO of My Food Bag, Cannasouth and Napier Port.

Know This: The majority of companies in the world are private. A private company is typically one which has grown through bootstrapping (using your own money), family and friends, angel investments or venture capital money. Companies that get to a certain size typically look for the next step in the growth journey, and sometimes the private markets can be limiting. However, just because a company is progressing with an IPO doesn't mean it's a reliable investment. There are many New Zealand companies who IPO'd because banks won't lend to them any more, and/or their original investors don't want to put any more money in. Be cautious about any IPO and never believe the hype - lots of money is made by existing investors by talking up the company to potential investors.

How an IPO Works
In an IPO, the first step is to price the company's shares. This is typically done by an investment bank that will conduct due diligence (look into the business's fundamentals and financial statements). A company will hire investment bankers to value the business, gauge demand from buyers, set the price and date, "underwrite" the transaction (underwriter breakdown below).

An IPO consists of two steps: (1) pre-market phase and (2) IPO itself.

1. The first step is to advertise to underwriters (Investment Banks) that the company is looking to IPO and will receive submissions from these banks looking to win the company as a client and do the associated work.
2. Once the underwriters are selected, they will lead the due diligence process (preparing documents, filing, marketing, valuation, etc.).

 
Steps of an IPO for a Company wanting to list on the sharemarket

1. The company chooses its underwriter(s).
2. The underwriter will value the company and choose the structure (with board approval).
3. The company works with accountants, lawyers and the company to formulate documents.
4. The company and its advisors prepare the initial filings and work with regulators (i.e. the FMA and NZX) to comply with listing requirements.
5. Executives of the company (i.e. CEO, Chairman/woman) go on a "roadshow", which effectively involves management and the investment banks to pitch the company to prospective public investors (hedge funds, fund managers, pension funds etc.
6. The company's bankers conduct a "Bookbuild" with the prospective investors to understand the indicative price and quantity each party is willing to buy and sell at. Once this is identified, a market can be identified, and an indicative price can be set for the IPO price. 

It depends on the company being listed. Some IPOs will increase by 100% on day one, while others will drop by 50%. Every IPO is unique, and each company will differ in the way it is valued, marketed and supported. There is no general "right time" for many reasons.

It's difficult to say whether an IPO will be overvalued, but in general – the investment banks do a very good job of pricing the company such that:

1. The early investors are happy with the valuation and aren't angry if they're selling their stake too cheaply
2. The institutional investors buying into the IPO aren't paying too much for the company (such that they will see it drop on day one)
3. The company "pops" on the first day of trading, typically leading to positive media posts and reporting. 

Whilst this isn't the case in every IPO, a banker's priority is ensuring all stakeholders are happy. The majority of the time, a large drop on the first day of trading does not keep existing or new investors happy, so it is in the company's best interests to underprice the stock rather than overprice it. Whether this is the case for a particular company will vary. ​

1. ​Compliance requirements is designed to protect investors from dubious IPOs
As an IPO is an offer to the public, the company must ensure the accounts, financial projections, and representations are correct. Public investors may not have the understanding or specialisation necessary to understand a business, so to protect the general public/retail investors, certain compliance standards are required to list on the stock exchange. These requirements can be relatively expensive to do.

2. Underwriters play a vital role
Underwriters act as a bridge between the company and investors. The underwriters will typically commit to buying a portion of the IPO amount, effectively providing a floor for the company if public investors do not purchase the shares. This is to provide some certainty to the company that the IPO will do "well", and the price will stabilise. 

A "Greenshoe Option" is a provision in the underwriter agreement that allows the underwriter to sell investors more shares than initially planned if demand exceeds a certain threshold (typically up to 15% more). This provides stability and liquidity to the markets and provides buying power to the underwriters in the case that share prices fall. 

3. There is usually a lock-up period to protect new shareholders
Underwriters (i.e. investment banks) are likely to get existing investors to sign agreements preventing them from selling their stakes (known as an escrow period) to stabilise the stock price once it has publicly listed. Lock-up agreements are legally binding contracts. Typical lock-up periods can range widely, but typical lock-up periods last anywhere from 3-24 months (with 12 months being most common). There is typically significant volatility (large price movements) around lock-up dates. ​

Why do lock-up periods exist?
To protect the share price in at least the short to medium-term, the promoters of an IPO require original investors to withhold from selling their shares and dropping the share price. For example, if a company had an IPO on March 10 and then an early shareholder sold millions of shares on March 15, the share price would, in most cases, fall significantly. To protect investors, lockup periods give certainty about how many shares will be sold off by the original investors.

IPOs have advantages to both companies and investors, but there are also clear disadvantages. We list the below to bring light to the reasons why some companies IPO and the risks, obligations and costs associated with doing so.

Access to deeper capital pools - There are millions of potential investors for a public stock. An IPO opens the gates for companies to get greater access to funding and grow faster where the private markets may have limited ability to provide funding. The public market presents an opportunity for these millions of investors to invest in a company's equity. These investors may not have had the prior access to invest in the stock, and as such, demand may significantly outstrip supply on IPO day. 

Brand Visibility - Taking a company public typically improves the company's exposure, prestige, and public image, which can, in turn, help the company's sales and profits. An IPO is also seen as a "milestone" for many companies (alongside $1bn USD Private unicorn valuation, becoming profitable etc.).

Cash-Out Opportunity - An IPO provides a chance for early employees and founders to have the option to cash out (providing liquidity to these early investors when and if they need it).

Increased Transparency - Listing on a public stock exchange improves the company's overall transparency for investors. It also raises the standard of oversight for the board of directors, which can lead to better governance.

The Process is Expensive - IPOs typically have fees associated with the listing, mainly contributing to ongoing maintenance and compliance. These can typically be a lot higher than raising money through private placements (e.g. $16m in listing fees was paid by MFB to IPO on the NZX).

Compliance Costs - Higher scrutiny and increased disclosure requirements exist as a result of being a public company. Ensuring the correct information is presented in the right formats will typically cost a company more money than if they were to stay private. 

Reporting Takes Time - When you're private, you only have to appease your investors, whereas once you're public, you're obligated to disclose things you likely didn't need to as a private company. This can be a significant drain on staffing and resources. 

Misaligned Incentives - A public company may have compensation packages of their executives tied to shareholder value. As a result, the stock price's daily fluctuations can impact employee morale, board incentives, and workplace culture. This may lead to short-sighted thinking by management (where they may only focus on improving next quarter's results at the company's expense). These skewed incentives may impact the company's long term future profitability and competitiveness. ​

IPOs are popular in overseas markets (the ASX and NYSE see IPOs weekly), but few and far between in New Zealand. When they are announced, the media often debates the prospects of the underlying business and its management. To help you understand whether or not the company being IPO's has strong foundations, we address (in detail) the most common queries below.