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What Is an IPO & How Does It Work?

October 18, 2021

An initial public offering (IPO) is when a previously privately held company sells shares to the public for the first time to either raise capital or broaden its base of investors.

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When a young, private company wants to raise money, it can try to borrow from a bank, ask its founders or early investors to put up more cash, or it can do an initial public offering, commonly called an IPO, by selling shares to the public for the first time. 

The IPO process transforms a private business with a few owners into a public company in which large numbers of outside investors can own a stake. For this reason, a company that embarks on an IPO is said to be “going public.”

What is an initial public offering?

An initial public offering (IPO) is when a previously privately held company sells shares to the public for the first time to either raise capital or broaden its base of investors. After the IPO, the newly minted shares of stock become available on an exchange. Investors can buy and sell the shares as they would any other publicly traded stock.

Recent examples of IPOs

Several popular name-brand companies have completed IPOs in 2021.

  • Poshmark Inc., an online marketplace for new and secondhand clothing, accessories, and home decor, sold its first shares to the public in January 2021. It trades under the ticker “POSH” on the Nasdaq.
  • Inc., an online platform offering legal advice to individuals and small companies, made its public debut in June 2021. It trades as “LZ” on the Nasdaq.

Facebook Inc. launched one of the largest and most anticipated IPOs in history in May 2012. The social media behemoth raised $16 billion in the sale. Since the IPO, Facebook’s stock has surged more than 800% as of late September 2021. Facebook trades under the ticker “FB” on the Nasdaq.

How do IPOs work?

Before a private company can make its debut in the public arena, it undertakes months of preparation.

The firm hires an investment bank with an IPO underwriter to guide it through the nuts and bolts of the process. The bankers analyze the company’s history and finances to calculate its value and determine a target share price. They handle the regulatory paperwork that the Securities and Exchange Commission (SEC) and public stock exchanges require.

The bank/underwriter also acts as a broker between the company and potential investors to sell the shares and ensure their widespread distribution. The bankers and company executives host so-called road shows to pitch investment firms, mutual funds, and other institutional investors on the stock and drum up enthusiasm for the IPO.

The company drafts a final prospectus—a document describing the company’s business, financial condition, prospects, and risks—which the bankers file with the SEC and distribute to interested parties.

Types of IPOs

There are two types of IPOs:

  1. Fixed-price issue. In this case, the shares are sold at the price to which the company and bankers have agreed. Investors know the price before the company goes public and must pay it in full when they apply to buy the shares.
  2. Book-building issue. With these IPOs, the price is sandwiched between an upper and lower band. Investors bid on the shares before the final price is determined. They specify how many shares they want and how much they’ll pay. The bids determine the final price.

Most shares will be sold first to brokerage firms, investment banks, and some well-connected individuals. Individual investors may get access if they have big accounts, long-term brokerage relationships, or a history of high-volume trading.

After the initial allocations have been sold, the shares begin trading in the open markets. Here, any investor can try to buy the stock through their usual trading method.

Why do companies go public?

A private company decides to do an IPO for an overarching reason—to raise capital from public sources. The motivations can include:

  1. Expansion. The company is looking to make a new product or open more locations. It wants to attract employees with its stock as a compensation incentive. It’s scouting for acquisitions, using its shares for a deal. Or it simply wants to sock money away for future projects or unanticipated setbacks.
  2. Debt. The company took on debt to get up and running and wants to pay down the obligation.
  3. Diversification. The founders poured their life savings into the venture. They want to diversify, recoup their investments, or cash out altogether.

Capital. The company is having trouble securing additional capital. An IPO requires the financial scrutiny and transparency that can open wallets.

Benefits of IPOs

Aside from improving a private company’s capital levels, expansion opportunities, and financial security, an IPO can boost the firm’s profile and credibility.

Going public creates a buzz about a company’s business, plans, and executives. IPOs, especially those of smaller companies with familiar products, increase publicity: Employees sometimes ring the bell on the New York Stock Exchange and the media covers the new stock’s fortunes.

An IPO can also persuade would-be investors that the shares are a smart bet. Public companies must release quarterly financial statements, report material corporate actions, and abide by governance laws. These requirements improve the transparency on which investors base their buy and sell decisions.

Drawbacks of IPOs

The requirements demanded of public companies also can become costly, onerous, and time-consuming. Once a company goes public, it must release regular updates on its earnings, revenues, corporate activities, and general financial health.  

Analysts who rate public companies report financial expectations to investors. If the company misses the analysts’ targets, the stock can crater. Conversely, if the company beats expectations, the stock may soar.

Public companies sometimes complain that focusing on “making the numbers,” and meeting or beating analysts’ quarterly earnings forecasts, distract them from valuable long-term projects that may lack an immediate payoff.

Public companies also may lose the culture and values on which they were built. Shareholders have infused the company with money and expect a reasonable return on their investment—even if the corporate managers disagree with the direction or the demands.

Shareholder activists have used their big equity stakes to force public companies to shed businesses, slash costs, cut or raise dividends, install new leaders, and otherwise veer from the company’s original blueprint. These so-called activist investors focus on delivering top dollar for stockholders and are generally impatient with the status quo.

The bottom line

Private companies often enjoy lots of support when they go public through an initial public offering. They work with professionals who understand the environment, process, and requirements; who will analyze the company’s financial strengths and weaknesses; and who will advise on whether, how, and when to price and proceed with an IPO.

IPOs are mainly a game for institutional and professional investors. Most retail investors who want to invest in IPO stock will wind up doing so after the shares begin trading on the public market.

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