I am curious to understand how a company valuation works? What determines a price of a share and the number of shares to be issued to the public?
Do Investment banks/initial investors buy shares before the IPO and at a lower price than what would be available to the public?
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Former investment banker here.
IPO’s involve a very detailed valuation process, in which the IPO firm provides a set of reasonable projections detailing their future financial performance. Depending on the industry, the investment bank relies on a range of relative and intrinsic valuation metrics. In a ‘traditional’ industry, in which the company is profitable, bankers will use analyses such as Discounted Cash Flows (DCF), as well as comparable company multiples.
The price itself is usually arbitrarily set and is a byproduct of a lot of variables, including existing equity ownership, the use of proceeds, and investor interest. Use of proceeds usually drives this the most. Think Shark Tank. The company is going to raise $100 million for x% ownership in the company. This usually varies company to company, but in a traditional case, if a bank determines that its client’s equity value is worth, say, $1 billion, and the management team wants to raise $100 million, then the bank will try to back into an acceptable ownership percentage that those $100 million of proceeds will represent. Banks usually set IPO prices between $20 and $30 per share, then they will solicit interest in the market for the company. If they receive more than anticipated interest, the bank may bump the equity value up while increasing the share price, or the share count. Oftentimes, the bank will provide a price range for the investors to buy into, and if the bank sets the price well, the IPO will increase in value on its first day.
The investment bank’s role is to underwrite the shares being offered to the public. The bank will market the shares to its large network of public equity funds that invest in IPO’s. The bank makes money by earning a fixed percentage of the proceeds sold, often between 5% and 10%.
There is a lot more to the process, including SEC correspondence, book building and management prep work. A company wishing to go public may take up to a year to file its first S1 form with the SEC, and then several more months to receive SEC clearance and sufficient investor interest.
Investment banks play a pivotal role in IPOs by assisting companies with valuation, underwriting the offering, and guiding them through the regulatory process. They act as intermediaries between the company and potential investors, ensuring a smooth and successful transition to the public market.
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