How does an IPO work?

The initial public offering (IPO) of a company occasionally spills over from the purely financial sphere to occupy centre stage in the news and catch the public’s enthusiasm. But what exactly is an IPO? How does it work and what is it for? myLIFE tells you everything you need to know.

Glossary

What is the stock market or stock exchange? The standard definition is a market where financial securities are traded between investors. In other words, the stock exchange is a market place where investors meet to buy and sell their financial securities.

But what are these “financial securities” and how do companies participate at this level? These securities can take a number of different forms, indeed, myLIFE has devoted a special feature to asset classes. For the moment, just bear in mind that the main types of financial instruments are securities that represent a share of the ownership (shares or equities) or of the debt (bonds) of companies active in the region covered by the stock market or looking to access investors in the relevant region. Other types of securities do exist, but the two cited above are the most relevant for us here.

An initial public offering (IPO) or stock market listing allows a company to open up its capital (shares) to investors, which enables it to raise funds to finance its growth.

Is there a stock market in Luxembourg?

There are many stock markets around the world, in New York, London and Tokyo, to name but a few, and some have joined together to improve their competitive position. This is the specific case of Euronext, a company operating several European stock markets across six countries, including France and Belgium.

Of course, Luxembourg also has its own stock market, founded in 1928. It works in a comparable way to other stock markets around the world, but has a couple of specific features, such as its specialisation in international bonds and sustainable finance. A real advantage!

The benchmark index of the Luxembourg Stock Exchange is the LuxX, which is a weighted index of the nine largest companies by capitalisation on the country’s stock market and which thus reflects the market trend.

The LuxSE (Luxembourg Stock Exchange) has worked in partnership with Euronext since 2000, which enables the two stock market platforms to interact. The benchmark index is the LuxX. This was created in January 1999 at an initial price of 1,000, and today includes the nine largest listed companies by market capitalisation in Luxembourg. To find out more about the Luxembourg Stock Exchange, visit www.bourse.lu 

Why become listed on the stock market?

Why would a company be interested in an IPO? To cut a long story short: it is a financial transaction. An IPO represents a means of raising capital and therefore additional financial resources for a company. But an IPO can also be justified as a means of opening up a company’s share capital to new investors, to replace or join its existing shareholders. An IPO therefore involves either an increase in share capital and/or a sale of some shares.

Although the end result of an IPO is unambiguous, it may be motivated by a variety of reasons: for example, the money raised may be used to invest, pay down debt or expand the company’s cash position.

Indirectly, an IPO is also an excellent means for a company to raise its profile and gain credibility by voluntarily submitting to the greater transparency and reporting requirements that go hand in hand with a stock market listing. In return for access to investors, there a certain number of obligations attached: annual and semi-annual reports, the publication of material information likely to have an impact on the stock market price, a public offering of financial securities, share buybacks, etc.

If well-managed, the communication surrounding an IPO can generate strong publicity for the event and high public interest that may push up the stock’s price. A company can send a very positive signal for its image with an IPO.

In any event, bear in mind that an IPO contributes to the internal growth (organic growth) of the company, or to its external growth (acquisitions, new markets, etc.)

Initial public offerings of shares

Everything starts with an IPO when a company, whether large or small, offers shares in its capital for sale. We talk about the company opening up its capital (in the form of shares) to new investors. During an IPO, shares may be offered to both institutional investors, retail investors and employees of the company.

How is the price set?

So how is this price, the share price, determined for an IPO? There a number of ways to determine the number of shares offered for sale and the price per share in an IPO: an open price offer, fixed price offer and minimum price offer.

• • The open price offer (OPO) is the most usual procedure whereby a price range is established for shares reserved for retail investors. The forces of supply and demand determine the initial price (and the volume of shares allocated) within the price range.
  • Fixed price offer (FPO): the company and the intermediaries handling the IPO fix the price of a share before it is offered for sale on the markets.
  • Minimum price offer (MPO): similar to the open price offer, the minimum price offer fixes a price floor in advance and counts on investor demand to bid this up.

The price of a share – when it is first listed on the stock market and subsequently – is largely based on the law of supply and demand. The more demand there is for a share, the higher its price will rise. Once the regulator, the market authorities, have approved the offer procedure outlined above, the companies, which are referred to as issuers, distribute shares on the market in a precise order.

Primary or secondary market?

A company’s shares are initially offered for sale on the primary market. This market is mainly the preserve of institutional investors (with retail investors on a secondary basis), as the major holders of capital. This includes banks, pension funds, retirement funds and insurance companies.

When these investors subsequently decide to sell their shares, this takes place on the secondary market, where we find traditional investors – savers like you and me. An analogy is often made with the market for new and second-hand goods, and this is appropriate to describe these two steps in the trading of stock market securities.

While any company can seek a stock market listing, it’s worth mentioning that this process is not free, far from it!

How much does it cost?

While any company can seek a stock market listing, it’s worth mentioning that this process is not free. The procedure requires the participation of many external players and partners: lawyers, bankers, auditors, consultants, etc. It’s relatively complex to carry out and of course costs time and money.

The initial price fixing phase that we have talked about also costs money, as does registration of the shares by the issuing stockbroking house. So in reality, only companies of a certain size can aspire to a listing.

What happens next?

What are the major consequences for the company following its IPO? Once a company is listed on the stock market, it is obliged to provide investors with detailed reports in a specific format regarding its financial situation and earnings. As shareholders, investors can influence internal decisions at the company, providing that their holding represents a substantial proportion of the company’s capital and that these shares have a voting right.

Another logical consequence of a stock market listing is that the company will be exposed to the fluctuations inherent in markets. The share price may therefore take off, or collapse. A successful IPO is hard enough to achieve, but afterwards, success in the secondary market represents a new challenge – the company’s share price development must not be allowed to dominate corporate strategy. And that’s a whole new story!

An IPO is a key moment in the life of a company – an opportunity to raise both financing and its profile. Although the regulatory protocol is onerous and costly, a stock market listing also represents a source of strong future growth, a signal of promise for investors, and a showcase for the general public.