IPO arcana: underwriting vs. sales, and the over-allotment. Who knew?

As I mentioned in an earlier post about FB, it’s surprising to see how little the financial media understand about how IPOs work–whether it be newspaper reporters and their firms’ related blogs, or the talking heads on cable.

Two aspects:

the over-allotment

In the case of FB, it was 63.2 million shares (the number is on the front cover of FB’s registration statement).   As noted in the sentence that gives the over-allotment number, this amount of stock is not included in the 421.3 million share figure listed in bold.

What is it, then?

The over-allotment is a kind of insurance or safety precaution that the company issuing stock and the underwriters build into the offering.  The company agrees to sell a specified amount of extra stock to the underwriters at the IPO price if the underwriters ask for it.  In the FB case, it was 62.3 million shares.

When the underwriters divide the stock up and sell it to clients, they distribute the larger amount.  So the FB stock sold to the public amounted to a total of 483.6 million shares (421.3 + 62.3).

If the issue goes well and the stock stays at a price higher than the IPO level, the underwriters purchase the extra stock from the company and deliver it to clients.  That’s the usual case.  For FB, that would have meant an additional $2.4 billion from the IPO.

If, on the other hand, the issue goes badly, the underwriters can buy stock in the open market at the IPO price up to the amount of the over-allotment, without taking any financial risk themselves.  Don’t ask me why, but underwriters are legally allowed to do this for a short period after the IPO is launched.

The underwriters did this kind of intervention with FB just before noon and again during the final hour of trading on its first day.

How do we know?

The underwriters make no attempt to hide their identity or their intentions.  They want other traders to know they have a huge amount of buying power and intend to defend the IPO price.

How did I find out?  I looked at a chart of FB on my cellphone.  I saw the stock stopped its normal minute-to-minute gyrations just after 11:30 and flatlined–just like when someone dies on a TV medical drama.  That’s not natural.  Someone was making a statement about the $38 level.

In listening to hundreds and hundreds of IPO roadshows, I’ve never heard the over-allotment mentioned–ever.  Professionals know it’s there.  For the underwriters, it would be like a restaurant saying it had a great food-poisoning doctor on call.

underwriting group vs. sales syndicate

This is really arcane.  There’s no reason to read any further, except that this distinction may explain the bad treatment of some retail investors in the FB IPO.

The money that brokers charge in an IPO is for two slightly different functions.

–They have a percentage interest in an underwriting group.  Although I use underwriter and broker as synonyms in everything I write, that’s not precisely correct.  The underwriting group buys the stock from the company and then resells it. It’s paid a small amount for taking the “risk” that the members will be unable to resell the stock.  Remember, though, that the brokerage companies have firm–though not legally binding–commitments to buy the stock from clients who know they’ll never see another IPO allocation if they renege (legally, any client can return the stock and get his money back up until shortly after the final prospectus is issued.  See my post on preliminary and final prospectuses).

–the underwriting group employs a selling syndicate to distribute the shares it buys from the company.  It’s made up of the same firms that comprise the underwriting group, but possibly in different proportions, based on the size and strength of institutional and retail distribution networks.  Normally, the selling commissions are much higher than the underwriting fees.

Why write about this?  The accounts I’ve read mention only Morgan Stanley as a broker whose retail clients received much larger allocations of FB stock than they anticipated.  My guess is that Morgan Stanley carved out for itself an especially large piece of the selling syndicate pie.

raising capital–traditional IPO, venture capital, crowdfunding (I): a traditional IPO

I want to write about what I think are the implications of the new legislation circulating in Congress to permit greater use of crowdfunding by start-up companies raising money.  But to do this I think I should outline the way corporate equity capital is typically raised today.

going public through a traditional IPO

This is still the best way to raise LARGE amounts of money for expansion.  That’s not the only reason for going public, however.

One of the many clichés on Wall Street is that small companies should raise equity capital when they can (in other words, when investors would kill to acquire shares in a hot new concept), not when they absolutely need to.  Better to have cash you don’t have a present use for than to find the equity market closed to IPOs in a recession.

A public listing will probably be seen by potential business partners as a sign of company maturity and stability.

A public listing allows a company to pay employees in stock and stock options rather than cash.  For techy start-ups, it’s the possibility of making a fortune on stock options by being in on the ground floor of the next Google or LinkedIn that lets the fledgling firms attract top-notch talent.

the IPO process

Anyway, let’s say a firm decides to go public through a traditional IPO.  What happens next? The firm contacts an investment bank.  It may be that the company’s CFO already has connections on Wall Street.  It may be that brokerage house securities analysts (who in many ways are marketing agents for the bank) have already been calling on the firm for a while and the company selects the firm the most influential of them works for.  Investment bankers may have made marketing pitches as well.

The investment bank performs several functions:

1.  it helps the firm gather the materials it needs to file a registration statement with the SEC

2.  it performs its own investigation that allows it to vouch for the company with its clients

3.  it forms an underwriting group and a selling syndicate to market the issue.  The salespeople will already have the necessary national and state licenses to sell equities; the firms will already have established that the securities are suitable investments for the clients they sell them to.

4.  it prepares a preliminary prospectus (called a red herring in the US because the fact it isn’t final is highlighted in red print) to circulate within its client network and obtains informal indications of interest

5.  it arranges a sales campaign that may include meetings between management and potential buyers

6.  it recommends the final issue size and price.

Until the past few years–when the big brokerage houses laid off most of their experienced analysts–the investment bank would also commit itself to have continuing analyst coverage of the firm.

there are lots more ins and outs, but that’s the basic process.


The traditional IPO route gives a firm access to the investment bank’s distribution network.

It also gets the company a lot of publicity.

In normal equity offerings, the underwriters buy all the stock from the issuer and take the (usually negligible) risk of selling the issue to investors.  At the very least, the issuing company gets a specified price on a given date.


The traditional IPO is expensive.  The investment bank may charge as much as 10% of the issue for its services.

In pricing the issue, the investment bank’s loyalty is divided.   The issuer wants a high offering price, so it gets the most money.  The bank’s biggest customers, on the other hand, want a low offering price so the stock will go up a lot on opening day.

Many small companies are below the minimum size that will interest an investment bank.


That’s it for today.  More tomorrow.

two stages in a US prospectus: preliminary and final

As long as I’m writing about IPOs, I thought I should make a comment about prospectuses.

hire an investment bank; prepare a prospectus

In the US, the first step on the road to offering securities to the investing public (“going public”) is to hire an investment bank to act as lead underwriter.  The underwriter will, among many other things, help the firm create the prospectus, an offering document that discloses to potential investors all material and relevant company information.

There are two stages in the life of a prospectus:  the preliminary and the final.

file the preliminary prospectus with the SEC

Once the prospectus is completed, it’s marked as preliminary and submitted to the SEC for approval, in a form S-1, or registration statement. 

Here’s the one LNKD filed. If you scroll down past the cover page of the S-1 to the prospectus itself, you’ll see that the first page has a lot of blanks, where the offering price and number of shares will eventually be filled in.  As well, there’s a narrow band of bright red print at the top.  It’s the following notice:

“The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

PROSPECTUS (Subject to Completion)

Issued January 27, 2011”

becoming “effective”

The SEC staff reviews the preliminary prospectus for compliance with the disclosure requirements of US securities laws.  It may ask the filing company for further detail or clarification.  Once the agency is satisfied, it declares the prospectus as “effective,” or in legal compliance.  When this happens, the prospectus may be distributed to potential investors.  But it’s still preliminary and contains the red warning notice.

the sales campaign

The preliminary prospectus is the main sales tool for the IPO.  One or more teams of top company management members may tour the country meeting investors, either one-on-one or in large groups.  There may be “virtual” meetings through audio or video conference, as well.  But these events tend to be heavily rehearsed and scripted.  The issue?  The prospectus is supposed to contain all material information about the offering.  So the last thing the firm’s legal advisers want is for some company representative to make an off-the-cuff remark that’s not in the prospectus, that someone later on tries to construe as relevant.

the IPO date; the final prospectus

Investors give their indications of interest.  The underwriter buys the issue from the company and resells it to clients (this is a more convoluted process than it seems, but that’s a topic for another day).

Only then does the final prospectus appear.  It’s distributed to investors after they’ve already bought stock.

Here’s the final prospectus for LNKD.   Note that the blanks have been filled in and that the red warning label, which includes the key statement:”is not complete and may be changed” has been removed.

the significance of “final”

In my experience, everyone does analysis of an offering using the preliminary prospectus.  When the final comes, it’s just stuck in a file–unread.  Legally, however, the final prospectus is important.  It is the official, complete disclosure of all facts relating to the offering.  Technically, investors have a short period of time in which to read the final.  They can return the stock to the underwriter if they don’t like what they see.

I’ve never heard of a case of an investor exercising this right.  My impression is most investors are unaware they can do so.

preliminary and final aren’t always the same

Nor do they know that last-minute changes to the prospectus can be inserted into the final that aren’t in the preliminary.  I’ve only seen this happen once.

Armand Hammer, the corporate buccaneer who was CEO of Occidental Petroleum years ago, decided to spin off IBP, a meatpacking subsidiary, in 1987.  The final prospectus revealed that Occidental had allocated to IBP an extra $1 billion in corporate debt above what was stated in the preliminary.  The move made the deal worth about 10% less, by my reckoning, than the preliminary prospectus made it seem.

Not a nice thing to do.  Not something calculated to make you ever trust anyone associated with the deal again, ever.  But, however ethically suspect, legally permitted.  This would have been a famous incident, and might have spurred regulatory changes, had the IPO not come in mid-October, the week before the crash on Black Monday.