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Initial Public Offerings generally involve one or more investment banks as «underwriters». The issuer enters a contract with the underwriters to sell its shares to the public. The underwriters then approach investors with offers to sell these shares.

A large IPO is usually underwritten by a «syndicate» of investment banks led by one or two major investment banks (lead manager). The underwriters keep a commission based on a percentage of the value of the shares they sell. Multinational IPOs may have as many as three syndicates to deal with differing legal requirements in the home country, the U.S. and other countries. Because of the wide array of legal requirements, IPOs typically involve one or more law firms.

Legal Requirements in the United States

The U.S. has the strictest legal regime in the world governing IPOs. Moreover, federal securities law applies not only to IPOs within the U.S., but to any IPO in the world that targets or is likely to target a large number of U.S. investors.

The IPO process is governed by the Securities Act of 1933 and the regulations of SEC; each stock exchange has separate rules that listing companies must follow. Smaller IPOs may also be significantly affected by state blue sky laws; these laws are usually pre-empted by federal law when the stock is to be listed on a major exchange or NASDAQ, but apply fully to certain medium-scale offerings on a local level.

Before the IPO begins in earnest, the issuer must draft a prospectus. The prospectus is a detailed overview of the company’s finances, history, operations, products, risk factors, industry environment, etc. The SEC actively polices the content of each IPO prospectus, and law firms are usually involved in the drafting process.

Under the Securities Act, until an IPO is registered with the SEC, no public offering of any kind may be made by the issuer or its underwriters. Any offering during this «quiet period» is called «gun jumping». After filing, the issuer and underwriters may advertise the IPO through a simple «tombstone» advertisement, listing the name of the company, the amount of stock being offered, the names of the underwriters, and other basic information. Private placement discussions and limited press releases are also permitted. Any written offers to sell stock must be accompanied by a copy of the prospectus as submitted to the SEC, which is usually stamped with a warning of its non-final status in red letters and therefore called a «red herring».

Once the SEC approves the prospectus, the price of the shares is finalized and the IPO enters a «free riding» period in which shares may be offered for sale in a number of ways, such as telephone calls, «road shows» and institutional visits.

The issuer is liable for any misstatement or omission in the prospectus; its directors and underwriters may also be liable if they fail to undertake a «reasonable investigation». Underwriters may defend against liability by completing a due diligence investigation of the issuer, usually involving outside lawyers and accountants.

Legal Requirements in the European Union

The EU does not have a central regulatory mechanism for IPOs, but has made several steps toward unifying European laws relating to IPOs, most notably the Prospectus Directive of 2003. In Europe, underwriters generally face joint and several liability for the underwriting of all the offered securities. This differs from the U.S. rule, where each underwriter is separately liable for their allotted portion of the offering.

Pricing

Historically, IPOs both globally and in the U.S. have been underpriced. The effect of underpricing an IPO is to generate additional interest in the securities. This leads to massive gains for investors who enter the IPO early. However, underpricing an IPO results in «money left on the table». Investment banks take many factors into consideration when pricing an IPO, and attempt to reach an offering price that is low enough to stimulate interest in the stock, but high enough to raise an adequate amount of capital for the company.

Investment Banks