What Are IPO Models? Purpose, Uses, and Advantages

March 25, 2023 Jayant Sharma Financial Modeling, Knowledge

The simple nature of ownership as once seen in ancient times is diametrically opposite to the business situation at present. If a king were to conquer the land, the business would be under his wing. Today concepts like equity break the ownership value of a business into small copies that can travel around the globe. Equity financing has taken the world by storm and nothing in the sphere has more buzz surrounding it than initial public offerings or IPOs. If you too have heard about IPOs and want to know how IPO models operate, keep reading to find out…

Before we begin to look at IPO models from a financial investor or the lens of pure theory as a financial student, we need to understand what does an IPO mean? Is it financially good or bad objectively? Such questions might plague your mind as a rookie investor looking to strike gold in one stock or another. The clear advantages and disadvantages also need to be outlined so that individuals who try to buy a stake in a corporation are fully primed to handle the risks associated with IPOs.

Even prior to buying a stock or a few key terms need to be addressed if a lackadaisical financial literate is concerned. They might be caught unaware of any financial assets requiring the slightest speculation. So, describing the process of IPO in detail comes next. Lastly, we shall get to the elephant in the room and discuss IPO models. IPO models and the process of modeling with an iota of information about the financial modeling of a company and the steps necessary in that process.

Now that we have spilt the beans for what is to come, you can rest assured that you have been given a ‘preference share’ in our books and will see this article on IPO models through to its end, no matter the cost.

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Equity Financing & IPOs:

Equity financing refers to the gaining of capital by a firm through the sale of its securities/shares. The effective sale of equity and financial assets for raising capital for long-term needs of the firm and cash flows for the short-term. IPO models are conducted on the basis of this concept and the resulting IPOs can be technically described as the sale of a company’s shares to the public for the first time. It describes the situation of going public for an entity where the company’s previous financial record is used to value the company at a point. As of recently, IPOs and unicorns have become a unanimous term often used in the same sentence. Unicorns are companies that possess a valuation of 1 billion USD or higher that are privately held. A lot of these companies can be bloated as I discuss later in the article, which is one reason offered as to why initial investment in IPOs is not recommended to people who are new to the field.

Ultimately, the aim of an IPO that is done by a company after 5 long years of work using multiple IPO models is to gain the maximum funds and expand business reach or increase the reach of products, goods and services. The benefits and disadvantages will be discussed shortly however, the important aspect that IPO models do not tell is the importance of a favorable price environment i.e., where prices are rising across the economy. Before that, however, let’s investigate…

Advantages & Disadvantages of IPOs:

IPO models and valuations are aimed to figure out the advantages and disadvantages of conducting an IPO in the market conditions, regardless of which there are certain objective advantages and disadvantages to an IPO. If you consider that IPOs can be constructed into estimated IPO models and they are based off of high valuation, doesn’t that leave little room for risk? No, actually as risk is rampant in cases of conducting IPOs, even after using IPO models to get relatively accurate ballpark figures on the turnover from going public. Let us not start out with negativity and begin by saying that the firm as well as the shareholders have two great benefits from IPOs. A firm’s capital can be increased without increasing debt incurred through loans extended by banks or financial institutions and the current shareholders can profit from liquidating their shares into the public sphere and gain a hefty benefit for buying in at a risky phase of the business’s growth.

Furthermore, IPOs are considered a hallmark of success for a business as it is considered to be proof that a company has made it in the financial markets. However, this fantastical claim may be queerer than unicorns themselves as it is not based on the grounded reality of business endeavors. In reality the disadvantages that are not considered under the valuations of IPO models are that after going public the regulations of government authorities come knocking. More report building and more costs regarding accounting, legal and marketing aspects of business are taken by the business in both trying to compete with open books and in creating a niche for its products and IPO shares.

Some may have a good earning history while others may be steeped in debt. Thus, an IPO only adds to the risk with less than appropriate capital formation and more certain costs. The key reasons that are genuinely problematic for investors to invest in IPOs are:

Lack of trading history – Even though the company prospectus is presented, and key details are highlighted, the general trading history and unavailability of transactions limits the forecasting ability of any public investor. The owner of the business knows more and will use that information or hide it to sell you more of the share at a higher price. Evaluation of future risk, current cash flow situation, financial debt sourcing and other key business wellness indicators cannot be calculated at times due to insufficient trading documentation.
Increased business volatility– After the lockup period for IPO shares is over there is a massive fall in stock prices which can obstruct the entire business’s valuation. Reducing volatility is key to good investments because no one is satisfied with risk increase for the sole reason of risk increase. This is where ten-year rule for investment becomes necessary. It is considered proper financial investing since a span of 10 years is sufficient time for business cycles to complete one rotation in its entirety. Learning how business handles stress and whether the management is trustworthy or not form important value judgments in good investing.
Lack of proper reports and documentation – Lastly, investing is only possible in a company where consistency is key and without it there is little that can be done by investors to assure decent returns on the shares they buy. This is like releasing an arrow in the wind and hoping that it takes a turn for the better.

The unique risk of IPOs is that you will be investing in something that has never made earned much for instance a company that has no earnings but shows great returns in the future after clearing its debt through an IPO is a high risk and high reward proposition for most investors who are looking for a business with a solid foundation.

Some investors just don’t want to invest in an IPO because they are typically overpriced and expensive for the value they offer and their future potential return on investment is not reliable. Some research studies on raising business studies have found that on aggregate, IPOs usually underperform. This is because of the simple fact that IPO models are built through a process that is essential to improve the capital hold of a company. Since as a result of an IPO, owners are relinquishing part or whole of their investment they want better returns than the principal amount invested. They look at the potential of growing sustainable trends on the part of the business conducting the IPO. However, investors wanna buy low thus IPOs often turn out to be counterintuitive to the entire endeavor.

Marketing is done for IPOs as many companies take out road shows to advertise the value of their shares once their companies turn public. During this road show going around to different investors is common practice so that investors join the bandwagon effect that forms around a new IPO which would turn out money in spades. Generous projections and such road shows are some of the reasons why IPOs can tend to inflate and grow larger than their actual value has many reasons we’ll discuss soon.

Before that, a favorable price environment is key to an IPO as these can be easily canceled if the business is skeptical of the IPO and its possibility of success. The bargaining power is all in the hands of the company as they can delay their IPO as long as they want and their insistence on selling only under suitably profitable conditions is the key they hold to the lock of price and capital raised for their company to an amount of their liking.

IPO Share Inflation – Unicorns:

Many unicorns in today’s markets have been falling in valuation of 1 billion after going public. Private valuations have been the yardstick by which companies are measured in the public domain for a long time but now they are constantly missing the mark. Often however these are over-inflated because of a few reasons such as:

Business valuation occurs each time the series of investments appreciates over time due to the growing interest in private investors who want their investments to perform better than the principal amount they paid coupled with improving factors in general. These investments are funded by private equity and venture capital firms who grab equity for cash in return for future benefit. Furthermore, factors like the size of market and the transactions therein, revenue sources and total revenue as well as management action and decision making.With rising stakes and valuations you must wonder why they are not opposing valuations? Because the skepticism is not to be found under private investing markets.

Companies also try to grab for greater valuations to gain more capital through eventual IPOs.this is done through preference shares like giving private investors above and beyond the necessary perks and benefits endowed by a common publicly shared stock. These shares have greater value and thus, tell the tale of why private value is higher than public value. Furthermore, there are multiple types of preferences shares found commonly in markets. Liquidation preferences for instance are preferential shares that hedge the share value at the principal amount. Ratchet is another example where companies insure against lower IPO to gain inflated private investment.

Accounting data is all distorted in a way to make it appear rosier and better than it is. They don’t need to work as per accounting principles i.e. GAAP or governmental regulation that functions to resolve transparency and reliability issues for the public market. In public markets the amount of checks and balances on the company can be essential to good comparison with other firms, increasing financial statement reliability. That was the precursor to understanding the IPO process and the construction of IPO models depending on that process.

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IPO Process:

IPO process requires investment bankers to underwrite the public offering of shares. This is done through the fact that underwriting consists of taking the shares of a company and selling them on behalf of the company.

Investment bankers ensure that companies get the most out of their share issuance in the form of capital and the underwriters in turn gain commission for the sale of these shares. An investment banker may set up a banking syndicate i.e., multiple bank party systems to create the proper valuation of the IPO and this will help with both IPO setup for administration as well as marketing purposes. Underwriting means that they will sell shares on behalf of the company and work as per a priority list of prime investors.

Registration statements follow soon after with credible authority of exchange and stocks. The statement put forward is uniquely important as it details the essentials of a company’s major operations, financial situation and top executives as well as management. This is done to check the competence of a company and whether the records check or sometimes even whether there are clear and credible accounting documentation. They will judge whether the IPO proposition is based on sound footing and whether there is risk control when exchanging shares publicly. If everything checks out, then the IPO date of a company is ensured on an appointed day.

The company and the syndicate will create a prospectus, a detailed account of the public offering of the equity in the matter of business administration and exchange control. It is headed by an investment banker/syndicate who includes the company’s financial performance and expected actions and processes in the future. This document is created and passed through the legions of investors and financial institutes to generate interest regarding the value offered through the initial offerings. The interested parties can submit indications of interest. These are critical to not only give the management an idea about the number of shares required for a full-fledged initial offering to the public as well as private investors. Decisions about price and float are made in this scenario. These factors lead to the establishment of the IPO price. Furthermore, there will be clarity about the shares to be allocated in the IPO.

After which the IPO is released to the masses leading to the settling of the shares of a company into the market price.

Purchase commitments from different institutions and brokerages as well as banks. Then make the shares available through different brokerages. Generally, to high-value investors, these shares are pledged for fair price in return for holding the shares for a while. There is then the release of the shares in the public market for exchange and the supply and demand of these shares determines their value.

IPOs can be a pain to handle because they induce many risk factors into a company however there is amazing potential for growth among these IPOs at large.

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IPO Models:

Models are key to the setup of any IPO as is the case in most business transactions and financing. IPO is a big financial decision for a company as it brings with it many strains as well as opportunities for growth. IPO modeling is a tool for better understanding the scope and extent of IPO as a financial instrument for raising capital and key in the development of projections of funding received as well as extremely useful for equity analysis and research. These models are designed in a way so as to bring out important pitfalls and key benefits of conducting an IPO for a company under various scenarios and come to a decision on what would be the most financially profitable for a business. It’s a winding process that is defined by 5 steps, namely:

Assumptions:

These are ideas formed by compiling the objectives and the funding that is necessary for a company to expand or sustain its output. It is interested in the total capital amount to be raised depending upon multiple factors such as the number of shares on sale, the financial plans of the company. At an average, the IPO funds raised is limited to ⅓ or ¼ of the valuation accrued by the entire business.

Trading and the Formulations for Price Discount: The multiple utilized in the assumption section is attached to the financial metric of Forward Net Income. This can get you the complete market cap of a company after it has raised the necessary capital and the price it is trading on at the stock market. Post IPO equity value is the key metric to be calculated here for constructing a thorough model for an IPO of a firm.
Whereas the sale of privately acquired shares by investors and institutes to individuals is considered as secondary shares. Secondary because the change in ownership is significant but since it does not meet the objective of an IPO i.e., the capital raising motive is not achieved. Since models need to care for share price and share volume, greenshoe option is available to reduce oversubscription to a stock due to market notion or popularity. Under greenshoe, more shares are shelled out to increase the amount of capital raised but not at a discounted price. It is an effective method to meet demand and fulfill investor expectations, raising the credibility of the company as well in the market.
Total Proceeds to Issuer: The proceeds of underwriting are given and modeled out by taking total offering size and then deducting the fees. They are compensated for the risk they hold by a sizable amount of stock they are given as security in case the shares are not sold.
Evaluation of Valuation Multiples: Equity value usually leads to the value of the enterprise as a whole however, once an IPO is conducted, the earnings from it need to be deducted from it to gain the true value of multiples.

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FAQs:

Q1. What is the 4 M method?

The 4 M method includes the most important factors of a business: man, method, machine and material. These are not only essential for improving the manufacturing and output of business goods and their services but are also a checklist that can be beneficial for investors to look into before making decisions about investing early. Reliability and consistency are key signs of a good investment prospect.

Q2. What is OTC (over the counter)?

Over-the-counter trades or deals are exchanges between two parties without the authority of board to guide action and ensure good practices.

Q3. What is a lock-up period?

Underwriters of a stock nudge company officials and owners to sign a contractual agreement that prevents them from selling shares of a company for a definite period. The period can range from a quarter to two years and leads to a fall in share value shortly after the lock-up expires.

Conclusion:

We hope you gained valuable insight into IPO and models of IPO through this article.