What’s an IPO? (Initial Public Offering)

➤ Simple IPO meaning

An initial public offering (IPO) is when a company first sells shares of its stock to the general public. It’s like a company’s way of saying, “Hey, everyone, now you can buy a piece of us!”

IPO Meaning: Key Points to Remember
1. IPO means a company is selling its stock to the public for the first time.
2. To do an IPO, a company has to meet certain rules from stock exchanges and government agencies.
3. IPOs help companies raise money by selling their shares to regular people.
4. Companies get help from investment banks to do all the IPO stuff, like figuring out how much to charge for each share and when to do it.
5. For the company’s founders and early investors, an IPO is like a payday because they finally get to make real money from their private investment.

➤ How does an IPO work?

Before an IPO, a company is private. Being private means it’s not selling its shares to the public yet.

It usually has a small number of shareholders, like the founders, their family and friends, and some professional investors like venture capitalists or angel investors.

An IPO is a big deal for a company. It’s when the company decides to sell its shares to the public for the first time. This lets the company raise a lot of money, which can help it grow and expand. Going public also makes the company more transparent and credible, which can help it get better deals when borrowing money.

When a company thinks it’s ready for an IPO, it starts telling people about it. This usually happens when the company is worth about $1 billion or more, which is sometimes called “unicorn” status. But even companies worth less can go public if they meet certain requirements and the market is good.

The price of IPO shares is determined through a process called underwriting. When a company goes public, the shares that used to be owned privately become available to the public. This means that the value of the shares held by the existing private shareholders is now based on the price that the public is willing to pay.

This is a big moment for private investors. They can choose to keep their shares or sell some or all of them to make a profit.

On the other side, the public now gets a chance to buy shares in the company. This means regular people like you and me can become shareholders. The company decides how many shares to sell and at what price. This new money from selling shares adds to the company’s overall value.

So, when a company goes from being private to public through an IPO, it’s a way for the private investors to make money and for the public to invest in the company. The number of shares sold and the price they sell for determine how much the company is worth after the IPO.

➤ The Story Behind IPOs

You’ve probably heard the term IPO a lot in finance. But did you know it’s been around for ages? The Dutch were the first to do a modern IPO. They offered shares of the Dutch East India Company to regular people.

Since then, IPOs have been a way for companies to get money from the public. They do this by selling shares that anyone can buy.

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Over the years, IPOs have had their ups and downs. Some years, there are lots of IPOs, and other times, not so many. It depends on things like new ideas and how well the economy is doing. For example, during the dotcom boom, there were tons of tech IPOs. Startups were eager to get on the stock market, even if they weren’t making money yet.

Then came the 2008 financial crisis, and IPOs hit a low point. After that, new companies going public became pretty rare for a while.

Lately, people are talking a lot about “unicorns.” No, not the mythical creatures, but startup companies worth over $1 billion. People wonder if they’ll do an IPO or stay private. It’s a big deal in the finance world.

➤ The Process of IPOs

Let’s break down how an IPO happens. It’s basically a two-part process: the lead-up and the actual IPO.

Getting Ready: Before a company goes public, it gets ready. It can try to get underwriters interested by asking for private offers. Or it might make a public announcement to create buzz.

The Underwriters: Underwriters are the people who lead the way in doing the IPO. The company gets to pick which underwriters it wants to work with. Sometimes, they choose more than one to help with different parts of the IPO process. Underwriters do everything from checking the details to preparing documents, filing paperwork, marketing, and selling the shares.

Proposals: Underwriters talk about their plan, like what kind of shares to issue, the price, how many shares, and how long it’ll take.

Picking Underwriters: The company chooses its underwriters and signs an agreement with them.

Teamwork: Teams are formed, made up of underwriters, lawyers, accountants, and SEC experts.

Paperwork: They gather all the info about the company for the IPO documents. The main one is called the S-1 Registration Statement, which has two parts: the prospectus and the private company info. This document gets updated a lot before the IPO.

Spreading the Word: They create marketing materials to get people excited about the new shares. The underwriters and company leaders go out and talk to people to see how much interest there is and what price makes sense.

Making It Official: The company sets up a board of directors and gets its financial reporting and accounting in order.

Shares for Sale: On the big IPO day, the company sells its shares. The money from selling those shares turns into cash and goes on the balance sheet as stockholders’ equity. After that, the value of the shares depends on the company’s stockholders’ equity per share.

After the IPO: There might be some rules that kick in after the IPO. For example, underwriters might have a certain amount of time to buy more shares after the IPO day. And some investors might have to follow “quiet periods” where they can’t do certain things with their shares for a while.

➤ Pros and Cons of IPOs

ProsCons
Raise CapitalPricey Process
Transparency PaysShare Price Stress
Lower CostsPublic Exposure
Attracting TalentManagement Hassles
Future FundraisingCostly Affairs
Time and Effort
Control Loss

Let’s take a look at what’s good and not-so-good about doing an IPO:

IPO Pros

Raise Capital: The main reason for an IPO is to get money for the business. It’s a way to bring in investments from the public, making it easier for the company to grow, make deals, and become more well-known. This can boost sales and profits.

Transparency Pays: Being public means sharing financial info every quarter. This helps a company get better terms when borrowing money compared to staying private.

Future Fundraising: Public companies can raise more money later by selling more shares.

Attracting Talent: Having stock that can be turned into cash helps companies get and keep good managers and skilled workers.

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Lower Costs: IPOs can make it cheaper for a company to get money, whether it’s through stocks or loans.

IPO Cons

Pricey Process: IPOs can be expensive. Plus, once a company is public, there are ongoing costs that don’t have much to do with regular business expenses.

Share Price Stress: When a company’s share price goes up and down a lot, it can distract the leaders. They might focus more on the stock price than on the company’s actual performance.

Public Exposure: Public companies have to reveal a lot about their finances, taxes, and business strategies. This might mean giving away secrets that competitors can use.

Management Hassles: Rigid rules by the board of directors can make it harder to keep good managers who like taking risks. Staying private or looking for a buyout are other options. There are also different ways a company can explore.

Costly Affairs: IPOs come with ongoing expenses for legal stuff, accounting, and marketing.

Time and Effort: Company leaders have to spend more time and work on reporting.

Control Loss: Going public means less control over the business, and it can lead to more conflicts of interest.

➤ Any Alternatives to IPO?

Direct Listing

A direct listing is like an IPO but without underwriters. This means the company takes on more risk if the offering doesn’t perform well, but it may also lead to a higher share price.

Direct listings are usually suitable for well-established companies with strong brand recognition and attractive businesses.

Dutch Auction

In a Dutch auction, there’s no fixed IPO price. Potential buyers place bids for the number of shares they want and the price they’re willing to pay.

The shares are then allocated to the highest bidders who offered the most competitive prices.

➤ How to Invest in IPOs

Investing in an IPO can be an exciting opportunity. When a company decides to go public, it’s after a lot of careful thinking and analysis. This decision is usually made when the company believes it can grow further and wants to raise more money.

That’s why when an IPO is on the horizon, it often grabs the attention of many investors who want to buy shares for the first time.

IPOs are usually priced lower to attract buyers, making them even more appealing. The initial price is typically determined by the underwriters, who use various methods to calculate it. They often consider the company’s expected future cash flows, among other factors.

While they do take demand into account, they usually set a price lower than what they think people will pay to ensure the IPO’s success.

Analyzing an IPO can be quite challenging. News headlines are helpful, but the most valuable source of information is the prospectus, which becomes available when the company files its S-1 Registration.

This document provides a wealth of information, including details about the management team, underwriters, and the deal itself. Successful IPOs are often backed by major investment banks that can effectively promote the new offering.

The journey to an IPO is long, and investors can stay informed by following news and updates along the way. The pre-marketing phase involves private and institutional investors, which can heavily influence the IPO’s opening day performance.

Individual investors get involved on the final offering day, but they need to have trading access through a brokerage platform that received an allocation of IPO shares.

In summary, investing in an IPO requires careful consideration and research. It’s essential to read the prospectus and pay attention to the details. While it can be challenging, it offers the potential for significant returns if the company performs well after going public.

➤ How to Profit from IPOs

The performance of IPOs can be quite interesting and is closely monitored by investors. Some IPOs get a lot of hype from investment banks, which can lead to initial losses.

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However, most IPOs tend to perform well in the short term as they become available to the public. Here are a few things to consider about IPO performance:

Lock-Up Period: After a few months following many IPOs, you might notice the stock takes a sharp downturn. This often happens when the lock-up period expires. When a company goes public, underwriters make insiders like officials and employees sign a lock-up agreement.

These agreements prevent them from selling their shares for a specified period, which can be anywhere from three to 24 months. The minimum period is 90 days as per SEC law, but it can be longer based on what the underwriters specify.

When the lock-ups expire, insiders can sell their stock, leading to a flood of supply and downward pressure on the stock price.

Waiting Periods: Some investment banks include waiting periods in their offering terms. These set aside some shares for purchase after a specific time. If underwriters buy this allocation, the price may go up; if not, it could decrease.

Flipping: Flipping is when investors quickly resell an IPO stock in the first few days to make a fast profit. This often happens when the stock is discounted and surges on its first day of trading.

Tracking IPO Stocks: Sometimes, existing companies spin off a part of their business as a separate entity, creating tracking stocks. The idea behind this is that individual divisions of a company might be worth more separately than as part of the whole.

This can be an interesting opportunity for investors because it provides a lot of information about the parent company and its stake in the divesting company. Spin-offs tend to have less initial volatility because investors have more awareness.

In general, IPOs are known for their volatile opening day returns, which can attract investors looking to benefit from discounts. Over the long term, the price of an IPO will settle into a stable value, and traditional stock price metrics like moving averages can be applied.

If you like the idea of IPOs but don’t want to take on individual stock risk, you can explore managed funds focused on IPOs. However, be cautious of so-called “hot IPOs” that may be driven more by hype than substance.

➤ Initial Public Offering (IPO) FAQ

Why companies use IPOs?

An IPO is basically a way for big companies to raise money. They do this by selling their shares to the public for the first time. After an IPO, these shares can be bought and sold on a stock exchange.

There are a few reasons why companies do IPOs:

  1. Raising Capital: One big reason is to get money by selling these shares. It’s like a company’s piggy bank.
  2. Providing Liquidity: It also helps the people who started the company (we call them founders) and early investors (the folks who believed in the company from the start) to get their money out. It’s like payday for them.
  3. Higher Valuation: And sometimes, going public can make the company look even better and fancier. This can help the company grow and do even cooler things.

Can I invest in an IPO?

Not always. Usually, there are more people who want to buy IPO shares than there are shares available. So not everyone who wants to can get in on the action.

But if you want to give it a try, you can do it through your brokerage firm. Sometimes, only the big clients of these firms can join the IPO party. Another way is to invest through a mutual fund or something like that, which focuses on IPOs.

Can I make money investing in IPOs?

IPOs get a lot of attention in the news. Companies going public like to make a big fuss about it. People like IPOs because they often make the stock price jump around a lot on the first day and shortly after.

This can sometimes mean big profits, but it can also mean big losses. So, whether it’s a good idea for you or not depends on the company’s plans (you can read all about them in something called the “prospectus”), your own money situation, and how comfortable you are with taking risks.

How do banks price IPOs?

When a company decides to go public, it has to decide how much its shares should cost. The banks that help with the IPO (we call them underwriting banks) are the ones who figure this out.

They look at how strong the company is, how much it’s expected to grow, and other important stuff. Sometimes, they don’t have much history to go on, especially if it’s a newer company. In that case, they might compare it to other similar companies.

But one big thing that matters is how many people want to buy the shares. If a lot of people are excited about it, the price can go up before the IPO happens.

References
  1. U.S. Securities and Exchange Commission – Form S-1 (Pages 4–6)
  2. U.S. Securities and Exchange Commission – Form S-1 (Page 1)
  3. U.S. Securities and Exchange Commission – What Is a Registration Statement?
  4. U.S. Securities and Exchange Commission – Revisions to Rules 144 and 145: A Small Entity Compliance Guide

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Pavlos Written by:

Hey — It’s Pavlos. Just another human sharing my thoughts on all things money. Nothing more, nothing less.