So now let's consider the nuts and bolts of how firms actually get listed on a stock exchange for the first time, a process known as an initial public offering, or IPO for short. To illustrate this process, let's take on the role of an entrepreneur in one of the most loved sectors of my hometown of Melbourne, Australia, the coffee sector. You're the founder of a successful business that has been busy supplying coffee to downtown office workers on your ever-reliable tricycle. Your business turns out to be a huge hit with the office workers, who are attracted to both your ethically sourced coffee, as well as your environmentally conscious mode of delivery. This success brings with it a significant challenge, though, in that now you need to take on some partners to help you cope with the workload. Fortunately, your brother and sister stand ready to assist, but solving labor problems is only part of the solution. You now require an injection of much needed cash. So, you will approach your friendly neighborhood venture capitalist, who, in return for an equity stake in your firm, is happy to provide some cold, hard cash. So there you are. You've gone from a sole proprietorship, where you owned 100% of the company, to now a privately owned business with multiple shareholders. The venture capitalists have taken a 29% stake, your brother and sister 10% each, but you still maintain majority ownership of the firm with 51% of the shares. Demand continues to grow. You think about expanding into other cities like Chicago. So now you consider floating your company via an initial public offering. Why float your company? Well, fortunately, there's a lot of research to tell us why companies have chosen to do this through time. The number one reason, according to this particular survey, was to create public shares for use in future acquisitions. That is, as a currency in takeovers. Second most popular reason was to establish a market price or value for the firm. And as we move down through the list, we see reasons that make perfect sense. To broaden the base of ownership, to allow one or more principals, that is founders of the firm, to diversify their personal holdings. And you'll see down towards the end, to allow venture capitalists to cash out. To demonstrate the IPO process, let's consider the e-commerce firm the Alibaba Group, a Chinese based firm initially. Alibaba listed in the US in 2014, raising approximately $25 billion, giving it a total market capitalization of over $230 billion. Now, the other $205 billion of shares were held by existing owners in the firm, predominately in China. Now let's consider the steps taken by Alibaba to get there. Step one is to engage an investment banker. The investment banker helps the firm, that's going to listing, produce prospectus, and then assist with the underwriting requirements. The prospectus is a legal document that also acts as a marketing brochure to attract investors to the company. The underwriter, for a fee, guarantees that all issued shares will be sold. And, if they're employed on a firm commitment basis, they'll be liable to purchase any shares that remain unsold at the conclusion of the float. So the underwriters have a very clear incentive to ensure that all shares are taken up. Alibaba's experience was as follows. They appointed a syndicate of banks to manage the process. They had Credit Suisse, Deutsche, Goldman Sachs, J.P. Morgan Chase, Morgan Stanley, and Citigroup operating as a syndicate. In addition, we had another 29 sub-underwriters who were engaged to market the deal and help bear some of the risk associated with the float. Step two is the roadshow. This is where the bankers start to earn their money. They'll hit the streets to market the float, predominantly to institutional investors, where they'll start to elicit non-binding orders for shares in the float in the process known as book-building. Now, this is a critical stage of the float process because it's here where we'll start to get information about what the subscription price for the float should be. If the subscription price is set too high, no one will want to subscribe to the shares in the float. If it's set too low, that represents an opportunity cost to the existing owners in the firm. Setting the price too low is also known as leaving money on the table. For Alibaba, in early September 2014, its advisers began a two week global marketing pitch designed to woo those investors. Alibaba filed a statement with the regulators following that marketing process where they indicated that they expect the subscription price to be somewhere between $60 and $66 per share. Step three, now we set the actual subscription price and list the shares. So we had an indicative range of between $60 and $66. Setting the subscription price determines the price that's paid by those who have already subscribed to the issue. Now these shares are issued in the primary market. That is, the funds are actually received by the issuing firm. Once those shares begin trading, they trade on the secondary market, on the stock exchange, where trading is determined by the interaction of demand and supply. And we'll only see a trade when the buyer and seller agrees to a price. On the 18th of September, 2014, Alibaba announced their subscription price of $68 per share. On 19th of September, shares began trading on NASDAQ and they closed at a price of ninety-three dollars and eighty-nine cents, implying a return of 38% to IPO subscribers who immediately sold on the market. That's eight point three billion dollars potentially left on the table. Is this example of IPO underpricing a one-off example? We'll consider that very question in our next session. So, in summary, the process of having a company's shares listed on an exchange is known as an Initial Public Offering, an IPO. And a company might seek to conduct an IPO for many different reasons. To raise new capital, to allow existing earners, including founders or VCs, to cash out, to identify the market value of the firm or to facilitate take-over activity. A company will generally engage in an investment bank to assist in the IPO process. And the bank itself will fulfill a variety of services, including managing the float, preparing the prospectus, and fulfilling underwriting obligations.
