Stock market questions: IPO and splits

Two questions.

First, when a company forms, is it then decided how many stocks there are? Or is ownership declared in percentages? When an IPO is, um, made(?) how is it determined how many stocks are up for grabs?

Second, when are stock splits done (is there a rule) and who decides?

First answer:
A company issues stock as a way to raise cash (an alternative to debt). Since debt is almost always cheaper than selling stock (think interest rate vs. dividends+appreciation), most companies borrow while they can at a lower rate and then later they might sell stock to raise even more at a later time.

When they decide to sell stock (partial ownership) in the company, they typically hire an investment bank to figure out how to get the most bang for the buck. You are correct; it’s not all that important how many shares they decide to put up for sale, all that matters is that number times the price they can get for it. If they sell 1 million shares for $10 each, the company obviously gets $10 million. The investment bank typically goes on a “roadshow” and gets scoop on how many shares at how much they can get from investors. Then the IPO is offered.

Second: There is no rule on when a stock must split. If the company decides to split its stocks then it declares it and the books are updated (double the shares, half the price).

oh, and the company can try and sell stock whenever it feels like it…the first time, which can happen anytime, is the IPO; subsequent ones are called Seasoned public offerings.

(hey, this MBA thing is coming in handy)

The “double the shares, half the price” part is a little misleading. The company trades you one share for two and since the company’s value is still the same, market forces cut the price in half so that the shares*price is about the same, ignoring signalling.

Splits are (typically) done when a share’s price gets “too high”. Some mutual funds (and many private investors) stay away from a stock in the $100+ range - thus to generate more interest, the $100 share is split into 2 $50 shares. That way, more people can get in on the action, but current shareholders take no hit in value.

“Reverse splits” work in the same way, only backwards. This happens when a stock gets too cheap. My former company (currently trading at around 40¢) almost did a reverse split that would have made those shares worth around $3.00 each. This is not a good thing to do (obviously), as it makes the company look desperate. But many fund managers also won’t invest in any stock that regulary trades below $10. When AOL-Time Warner was flirting with dropping under $10/share, this became a concern for them.

Wow, quick and complete answers. I love it.

But one thing left hanging: when a company is formed but not public, are there any stocks at all?

And I’d never heard of a reverse split. Ouch.

Yes, private companies can issue shares and sell them directly to shareholders. This is called a privately held company. The only difference is there is no public market (like NYSE or Nasdaq) to trade the shares on, so any trades must be done manually person-to-person.

You don’t pluralize stock that way. If you speak of stocks, that implies that more than one company is involved. A single company has stock, period.

And yes, even if a company isn’t public, it has stock. Stock is equivalent to ownership. Every company is owned. If the company isn’t public, that just means that none of its shares are publicly traded on a stock exchange. If you wanted to buy stock in such a company, you would have to negotiate privately with one or more of its owners.

Yes, there are stocks (if it’s a corporation). My Dad’s business was a private corporation and had stocks, but the only people that owned the stock were himself, his mother and two of the long-time employees.

Likewise, one of my former jobs is still a private corporation - I own 2500 shares of the company. They are essentially worthless right now, unless I can sell them to an individual, perhaps another employee that wants a few more shares. However, the whole reason to go IPO is to have those stocks traded on the open market, where I could more easily find a buyer for them. Assume for argument’s sake that the company did an IPO for $10/share and ended up trading for (on average) $25/share. Since I paid only 16¢/share for them, I’d make a huge profit of $62,100 ($25/share x 2500 shares - 16¢ x 2500 cost). That’s why stock options were such a big deal several years ago.

TRIVIA ALERT: M&M Mars is a huge company, but is still privately owned. I believe that only 8 people own all the shares of a company worth billions.

^^^ "the whole reason to go IPO - I mean that as an employee. Obviously the real “whole reason to go IPO” is for the company to raise vasts amounts of cash buy selling said shares on the open market. But as an employee\share holder, that’s why you want it to go public. Wow - nitpicking my own posts! :slight_smile:

When a company forms, there is some large number of shares authorized, say, 100,000,000. The company then issues some number of shares to its founders, say 20,000,000 shares total.

Now, at this point, the founders own 100% of the company. However, the company still has authority to issue up to an additional 80,000,000 shares. Say a venture capitalist comes along and invests a pile of cash. In return, the company agrees to issue the venture capitalist 20,000,000 shares. Now the founders still own their original 20,000,000 shares but the venture capitalist owns 1/2 of the company, or 20,000,000 of the 40,000,000 shares outstanding.

After awhile, if all goes well, the company will want to go public as this is a necessary step for the founders and VC to cash in. It’s time for the IPO. The company, on the advice of an investment bank, might decide to issue 40,000,000 shares to the public at $10.00 per share and raise $400,000,000 (Oddly enough, the company doesn’t know exactly how much money it will raise until the morning the deal actually becomes final and start trading.)

Assuming the deal goes, there will now be 80,000,000 shares issued and outstanding out of a total authorized 100,000,000 shares. The public, which now own 40,000,000 shares or half the company. The founders and VC will own the other half. The company can still issue an additional 20,000,000 shares to raise money at some later date. (Note – it’s also possible to increase the number of shares authorized.)

Now typically what happens is that all the founder and VC stock is restricted for some period of time and can’t be publically traded. This means that, though the total shares outstanding is 80,000,000, the number of shares freely trading is only 40,000,000 so long as the founder/VC shares are locked up. Once the restrictions are removed, however, the founders and VC can sell their shares on the open market. Just for completeness, I should mention that sometimes, some of the founder/VC stock is sold directly in the IPO, thereby allowing them to cash in directly. Investors, however, frown on this in any significant amount since the idea is that the company will end up with a big pile of cash to invest, thereby making the company even more valuable. They don’t like it when the money goes directly into the founders’ pockets since that cash never benefits the company.

The Board of Directors decides. There are various reasons to do them. Sometimes, it’s a clever way to pay a tax free dividend. Reverse splits are usually done out of desperation when a stock is in danger of falling below some listing threshold, e.g. $1.00 per share for NASDAQ.

It should also be noted in light of the tech wreck that it was common for the dot com IPOs to sell to the public significantly less shares than were in private hands. This had the effect of overvaluing the companies on the inflated value of the few million shares actually in circulation. It also made for the paper billionaires who owned the original shares.

It should also be noted that I-banks have been ripping off their customers (the issuing companies) for quite some time when it comes to IPOs. Everyone talks about the IPO’s that skyrocket on their first day and this makes the bank (and their best customers) a pile of money. Of course, what an IPO is supposed to do is make the issuing company a pile of money to fund new projects, equipment, or whatever. Now, of course you can’t really predict what a stock will do, but the I banks are paid a ton of money to figure this out. If I were the CEO of a company that paid lots of money to a bank to have them value and underwrite my IPO at $20 a share, then they turn around and sell for $100 a share on day 1, I’d be royally pissed. That money (or a lot of it anyway) should have gone to my company.

Course, in this economy, most IPO’s don’t pop much at all. Guess the banks got better at valuation :smiley:

Actually, IPO’s over time have been shown to be overpriced. I believe the “over time” frame only had to be six months as well. Yeah, the same day it would shoot up and stay up for a while, but even the tech stocks would fall. Remember, the market won’t rest until these things are fairly priced, so if the i-bank set the price too high then the winner’s curse would kick in.

Just a little nitpick here. Splits are usually 2 for 1, but not necessarily. They can be 3 for 1 or 3 for 2, or just about anything.

Case in point concerning splits not being mandatory - BRKA. Warren Buffett doesn’t believe in splits, and BRKA is now running at a bit over $60K / share.

Another point on IPO’s - most brokerages have so-called “anti-flipping” rules which apply if you purchase IPO shares. “Flipping” an IPO refers to the practice of selling it immediately during the initial runup. To participate in an IPO which your brokerage is part of, you usually have to meet some criteria the brokerage sets - For instance, I believe Schwab limits it to their “Platinum” signature level, which requires your account to have $500K. Even at that, it may take quite a bit of luck to get in on the limited IPO shares that are offered. Flipping isn’t illegal, but it’s like being warned off at the racetrack - your broker is never going to let you have IPO shares again. Usually, anti-flipping policies force you to hold onto the shares for some interval like 30 to 90 days before selling them. In fact, it’s one of the things that contributes to the initial runup of a hot IPO, as well as the fact that founder / VC shares are in lockup.

It’s not quite that simple. It’s true that the lead underwriter isn’t keen on having everyone try to flip out on the first day of trading. Underwriters typically “stabilize” the stock price of the IPO for a short period of time, typically 30 days, after the deal starts trading. As a practical matter, this means the underwriter may have to buy back a lot of stock at or near the issue price if there are lots of sellers and no buyers. This is one of the reasons why IPOs are “underpriced.” The ideally priced IPO will close about 10% higher than the issue price on the first day of trading.

On the other hand, if everyone bought and no one sold on the first day, there would be no stock to trade on the market. Now unless its a very, very hot IPO, having everyone trying to come out on the first day of trading would be a complete disaster. However, so would having no one come out.

Happily, the market works pretty well. The hotter the IPO, the faster the price will run up and the more incentive there will be for people with IPO stock to get out quick. When the IPO is very oversubscribed (hot), you won’t get much stock. You may ask for 1000 shares and get 100, or none at all. Brokers often use hot IPO stock to reward good customers since it is, in effect, free money. In other words, you get the chance to buy 100 shares of something for $10.00, the IPO price, that’s now trading at $20.00.

I’m studying stocks and IPO’s and such in my accounting class right now. My professor made a mention of reverse splits. When I asked him why a company would ever do such a thing he said, “Sigh…I knew someone was going to ask me that!”

Basically, he told us that one of the reasons a company might do that is if their stock price becomes too low. I think most people tend to shy away from stocks that are really, really cheap, as it can mean that the company isn’t doing too well. If they do a 1 for 2 stock split (or a 1 for 3, or 1 for 4, ect.), it usually doubles the price of the stock. This might bring about more interest in the stock.

Of course, this is only from my 2nd semester accounting class. Anyone one out there with an MBA or some equivilant want to shed some more light on this?


that’s why: avoiding low prices to meet mutual fund thresholds, low ego from having a penny stock, more attractive (in-line and typical) price, reduce number of shares outstanding if it’s mad high. in less financially sophisticated countries, some owners would do a reverse split like 10,000-to-1 just to strip anyone with fewer that 3,000 shares (i.e., most everyone) from their shares and then liquidate the company and run. Banned in USA.

Hey, Truth Seeker, that was a truly enlightening post. One question remains, though.

How is this process carried out? Does it require an amendment to the Articles of Incorporation? Who issues final approval? The SEC?