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Understanding IPOs

An "initial public offering" (IPO) is typically used when a business decides to "go public" to raise capital by offering ownership interests in the company to the public at large. The federal securities laws require the company to file a "prospectus" to disclose to investors all facts about the IPO. An IPO may also involve following the securities laws of all 50 states and foreign countries, in addition to complying with federal law.
The "securities" being offered can include:
  • Shares of stock in a company
  • Bonds
  • Notes
  • Debentures
  • Evidences of indebtedness
  • Limited partnership units
  • Memberships
  • Other types of investments in a company  
A public offering can be quite complicated and is usually not undertaken by a company until the company has had a chance to prove itself and has a profitable business model that will scale to much larger operation on a regional, nationwide, or even international levels. Moreover, the company must have a strong business plan in place with clear objectives on why it wants to go public. These objectives may include raising millions of dollars of capital to fund an expansion and growth of a very profitable business model.
All offerings of stock and other securities are subject to the federal securities laws, as well as to the securities laws of any state where the securities are being offered or sold. Unless there is an exemption that applies to a given situation, these laws generally require that an offering go through a difficult securities registration process.
There are two federal laws that apply when a company wants to offer and sell its securities to the public:
  • The Securities Act of 1933 requires a company to give investors "full disclosure" of all "material facts" relating to the investment, including anything that investors would find important in making an investment decision. This law also requires a company to file a registration statement with the Securities and Exchange Commission ("SEC") that includes information for investors.
  • The Exchange Act of 1934 requires publicly held companies to continually disclose information about business operations, financial conditions, and management. These reporting requirements are rigorous and continuing. They may apply not only to a company itself, but also to officers, directors and significant shareholders.  
Each state has laws that apply to stock offerings and issuing securities. These are sometimes called "blue sky" laws because they are designed to protect the public against offerings that might be trying to sell nothing more than the "wild blue yonder." These laws usually parallel the federal securities laws to some degree, but state laws vary.
Civil penalties for failure to comply with the securities laws can be severe. Investors who are able to prove that they were defrauded can collect money from the company. At a minimum, misrepresenting the facts or failing to follow securities laws when making a securities offering may entitle an investor to a full refund, plus interest and attorneys fees.
Given the complexities of an IPO, many companies going through the process will contract with one or more brokerage houses to "underwrite" the offering. The brokerage house works with the company to place the stock to be issued. Sometimes, this involves the brokerage house essentially guaranteeing the company that a certain amount of capital will be raised, with the expectation that the brokerage house will be able to raise proceeds in excess of the guaranteed amount and pocket the difference.