How Investment Banks Make Money On IPO's

Investment banks charge a 7% fee when they take a company public.  This article (via Manan Shukla) shows that the 7% fee is only a minor portion of the value that investment banks derive from an IPO.  They make much more by providing shares to their customers prior to the public offer.  The shares typically increase in value when they market opens for public purchase.  Their client then sells the shares at a big profit.  In return for this favor, the investment bank requires that their client give them "soft money" in return.  That can come in different forms, but it frequently involves commissions that the bank earns on trades made by their client. 

This was a great way for the banks to make money during the dot com boom.  IPO's were more frequent and the payoffs to the banks and their clients were substantial.  It also shows the power that the banks hold over the firms that employ them to raise money.  The banks can make it difficult for complainers to raise money.  They control the fund raising process.   It also helps me to understand why the banks can sell toxic securities to their clients during the real estate boom and not lose them as customers.  The banks control the carrot and the stick.  They can provide favors, like when they issue IPO's, and they can also punish by control over the credit markets.