Initial Public Offering (IPO): What You Should Know

September 01, 2023 00:29

If you’ve been reading the news over the last few weeks, you may have read about the upcoming IPO of a chip designer named Arm. But what is an IPO? Why do companies undertake them? And what’s the big deal about this particular one?

What Is an IPO?

An Initial Public Offering (IPO) is a process by which a private company issues new shares to sell to the public and, in doing so, becomes a public company.

After going public, a company’s shares are listed on a stock exchange, such as the London Stock Exchange or New York Stock Exchange, where they can be exchanged between buyers and sellers throughout the trading day.

Although it has traditionally been the most popular route for going public, it is not the only method available. Other methods include going public using a Special Purpose Acquisition Company (SPAC) or a direct listing, both of which have gained an increasing amount of traction in recent years.

Why Go Public via an IPO?

The main benefit and reason for going public via an IPO is money. By issuing new shares and selling them to the public, a company can raise a substantial amount of capital, which it can then use to fuel future growth, pay down debt or fund a new project. Becoming public also allows a company to raise additional capital in the future through a secondary offering.

Moreover, often, IPOs are surrounded by a significant amount of publicity – case in point, the upcoming Arm IPO – which can help increase public awareness of a company, promote their products and potentially increase their market share.

Becoming a listed company also provides liquidity to existing shareholders, who gain the option of selling their shares on the public market, something which isn’t possible whilst the company is private.

How Does the IPO Process Work?

In order to go public, a company will need to enlist the services of an underwriter, usually an investment bank, which will lead the majority of the IPO process, charging a big fee for their service which can be as much as 7% of the total capital raised.

The underwriter will help the company going public decide how many new shares to issue and will also value the company to decide what the IPO price will be. They are also given the task of publicising the IPO, stoking interest amongst potential institutional investors and, ultimately, selling the shares. The IPO is the first opportunity that non-private investors will get to invest in the company, in what is known as the primary market.

However, a lot of the time, this opportunity to invest in the IPO is limited to institutional investors, other investment banks, hedge funds and high-profile investing clients. The majority of retail traders and investors will instead have to wait until after the IPO to buy shares, in what is known as the secondary market.

As the term implies, the underwriter also takes on a huge risk on behalf of the company by committing to buy any shares that are not sold to other investors during the IPO. This gives them an incentive to under-price the shares, something that has historically led to an increase in price at the start of trading on the day of the IPO. This is sometimes called the “IPO pop”.

Why All the Fuss About Arm?

IPOs often garner a fairly large amount of press coverage, particularly big money IPOs like Arm, which is apparently valued by parent company SoftBank at around $64 billion. However, Arm has attracted a particularly large amount of attention as its IPO arrives after a bit of a lull in the IPO market.

Following the “year of the IPO” in 2021, a record breaking year in which a total of 2,682 IPOs across the world raised a combined $608 billion, the IPO market slowed considerably in 2022. Severe economic headwinds, global uncertainty and lack of investor appetite contributed to the number IPOs launched in 2022 dropping sharply to 1,154. Between them, these IPOs raised a comparatively modest $173 billion.

Specifically in the US, where Arm is due to be listed on the Nasdaq stock exchange, just 93 IPOs were launched in 2022, raising a total of $24 billion. This was down from 1,115 IPOs the previous year, which raised a total of $346 billion between them.

Whilst it’s not certain yet how much the Arm IPO is hoping to raise, if SoftBank’s valuation is accurate, Arm is set to be the most valuable company to complete an IPO in the US for almost two years, when Rivian Automotive listed with an initial market capitalisation of $70 billion.

Consequently, other private companies keen to launch IPOs themselves are likely to be watching closely. If its IPO is a success, Arm could kickstart the beleaguered IPO market in the US.

What to Expect from the Arm IPO

SoftBank will be hoping that this IPO is more successful than its previous attempt with WeWork, an investment fiasco which cost the company billions. After failing to successfully launch an IPO in 2019, WeWork eventually went public via a SPAC in 2021.

At the end of WeWork’s first trading day, its market capitalisation was around $9 billion. Today, it’s less than $100 million and is reportedly close to filing for bankruptcy. In total, SoftBank invested more than $10 billion for its 46% stake in WeWork.

So onto Arm. The UK-based company’s main source of revenue is from IP licensing. As opposed to manufacturing and selling its own chips, Arm charges chipmakers a percentage-based fee for using its chip designs.

These designs can be found in pretty much every smartphone on the planet, a market in which it has a share of more than 99%. Incredible, yes. But when a company owns 99% of its market, where does it go from there? Such domination also leaves Arm heavily exposed to fluctuations within the smartphone market, a market has seen falling sales in recent months.

Moreover, potential investors have reportedly been concerned by Arm’s exposure to China, a region on which it depends for around 25% of revenue. At a time when the relationship between Beijing and Washington is seemingly deteriorating, and Washington has begun imposing restrictions on US chipmakers’ Chinese operations, this dependence on China could deter investors.

Consequently, those considering investing in Arm after its IPO may want to approach this investment with caution. It might be prudent to wait and see how the market reacts to the first blockbuster IPO in the US for almost two years.

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External Sources

  • PWC – Global IPO Watch 2021
  • PWC - Global IPO Watch 2022

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

Roberto Rivero
Roberto Rivero Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s