What is an IPO?

Table of Contents:

  1. SPAC IPOs vs. traditional IPOs
  2. Understanding how IPOs work
  3. Essential IPO terms
  4. The Initial Public Offering (IPO Process)
  5. The benefits and risks of IPOs
  6. How to gain access to IPO stocks
  7. The bottom line

An initial public offering (IPO) is the process where a privately owned company offers stocks for purchase to the general public for the first time on the stock exchange to raise capital. Although we may think “going public” is only for large, wildly profitable companies, there are plenty of small companies that decide to go public as well.

One look at the New York Stock Exchange (NYSE) or Nasdaq, and you’ll see thousands of companies listed. The size of the companies can range from household names such as Visa and Johnson & Johnson to smaller, less popular companies such as Malibu Boats and Eyepoint Pharmaceuticals.

Each company started as a small privately owned company and grew over time to attract investors and raise capital as they went public with their initial public offering (IPO). So, what is a public company? It’s a publicly traded company listed on the stock exchange where the public can buy stock and have an ownership interest in that company. The value of a company is in part determined by the decisions of major stockholders and the share price of the stock.

Key takeaways

  • Initial public offerings (IPOs) are when a privately owned company decides to go public for the first time and offers a number of shares of its stock to the public on the stock exchange.
  • IPOs offer companies a way to raise capital for research, growth, and expansion.
  • The process of offering an IPO is long and involves hiring an investment bank as advisors who set prices and dates, market the company, and handle finances.

SPAC IPOs vs. traditional IPOs

SPAC IPOs (special purpose acquisition companies), also known as blank check companies, refer to companies that don’t have commercial operations to complete an IPO. SPACs are formed for the purpose of raising money through an IPO to merge with an existing company to take it public.

The main differences between SPAC IPOs and traditional IPOs are:

  • The time it takes to complete the process.
  • The number of disclosures required to be filed with the Security and Exchange Commission (SEC).

Some companies agree to be acquired by SPACs to speed up the progress of going public. For example, whereas an IPO may take 6 to 9 months, a SPAC may only take 3 to 6 months, speeding up the timeline significantly.

Similarities between traditional IPOs and SPAC IPOs

The commonalities between IPOs and SPACs is the necessity to get approval from the SEC, raise money through an initial public offering, and list the company on the stock market. But there are a few differences as well.

Differences between traditional IPOs and SPAC IPOs

One of the most significant differences between IPOs and SPACs is the time it takes to move through the process. The reason is that SPACs don’t have as much information to disclose, so filing doesn’t take as much time.

Pricing also is approached differently. For a traditional IPO, the price depends on the condition of the market when it’s listed, whereas, for a SPAC IPO, the price is set before the transaction is finalized, which can be beneficial to the company in a volatile market.

Another important difference is the complications that can arise during the process. Traditional IPOs are scrutinized throughout the process from the very beginning to the end, which makes the chances of a successful transaction more difficult. SPACs don’t have the same regulatory guidelines, which simplifies the approval process.

Understanding how IPOs work

What is IPO stock? When a company decides to go public, it usually already has some business growth and support from family, friends, and possibly other professionals who have invested in the company, such as angel investors.

Angel investors are individuals who provide financial backing to start-up companies and entrepreneurs for some type of equity in the business. These investors may be friends and usually invest in the early stages of the business to help it get off the ground.

Of course, deciding to go public is a big step. Although it gives the company the ability to raise a significant amount of money to grow, it’s also a long process that can be costly and have difficulties.

As previously mentioned, some requirements need to be met for the Securities and Exchange Commission (SEC), which oversees public companies. In addition, there’s a lot of paperwork and disclosures to file, and the increase in attention and scrutiny by the public can be fierce and very stressful.

That’s why hiring an investment bank to manage the IPO is a huge benefit. They act on behalf of the company to help set the price for the offering, prepare the IPO, and schedule meetings to get the company in front of potential investors, which is called a roadshow.

In most cases, before going public, the company would have reached a stage known as unicorn status, which describes a privately owned company that’s valued at over $ 1 billion. However, in some circumstances, a private company may qualify for an IPO if it meets the other offering criteria and has a strong profitability potential.

Investment banks or underwriters are a party that assumes the risk for another party (the company) for a fee such as a commission or interest. They set the price of the shares of the company through a process called due diligence, which is a review and audit of the company’s financials, to make sure the records are a fair and correct representation of the company.

When the price is set, shares are issued to investors, and the stock starts trading on the New York Stock Exchange (NYSE) or the Nasdaq, which provides an opportunity to sell shares to millions of investors. But, again, the benefit is the ability to raise a significant amount of capital.

Reasoning behind why companies pursue IPOs

Although the Initial Public Offering (IPO) is the public’s first time being exposed to the company’s stock, the company already has investors in the form of family, friends, and venture capital investors. Therefore, one of the purposes of the IPO is to allow those early investors to cash out if they choose to do so.

Reasons a company goes public:

  • Companies aim to raise additional capital for research, to expand and grow their business, and pay off debts.
  • IPOs offer opportunities for growth through publicity.
  • IPOs add credibility to the company, which can provide additional financial options from lenders.

Challenges in going public:

  • Meeting qualifications for the Securities and Exchange Commission (SEC).
  • Must answer and be accountable to stockholders.
  • Filing quarterly documents and annual reports.

Essential IPO terms

Investing, like all industries, has terminology that can simplify understanding, so we’ll cover the most essential terms used or heard when investing in IPOs.

  • Allocation – is the amount of stock in an initial public offering (IPO) sold to investors.
  • Add on offering – when publicly traded companies issue additional shares to the public.
  • Common stock – units of ownership in a public company that offer voting rights and dividends from the company’s growth.
  • Best effort – the arrangement where investment bankers, acting as agents, agree to make their best effort to sell the shares to the public.
  • Due diligence – when a thorough investigation is conducted into the company by the parties involved to prepare disclosures for compliance with the SEC.
  • Preliminary prospectus – a document that discloses information about the business, such as financial documents and statements, strategies, and management information.
  • Underwriter – the investment bank that manages the IPO offering for the issuing company, which determines the stock issue price, markets the IPO, and assigns shares to investors.
  • Effective date – the day the IPO is registered for sale.
  • Price brand – the price range that investors can bid for shares. It’s determined by the company and the underwriter.
  • SEC – the Securities and Exchange Commission, a federal agency that regulates and supervises the securities industry, which enforces rules to protect against malpractice and ensures companies provide full disclosures.
  • Venture capital – money raised to assist start-up companies in developing and marketing their products and services. In return, they receive an ownership interest in the company and possible seats on the board of directors.
  • Roadshow – a tour the company takes in preparation for an IPO to gain interest from potential investors. It’s an invitation-only event for institutional investors, analysts, and money managers. It can sometimes be referred to as a dog and pony show.
  • Offering date – the first day the stock is offered for sale to the public.
  • Offering price – the price the stock will be sold to the public, also known as the issue price.
  • Lot size – the smallest number of shares that can be bid on before having to bid multiples of the lot size.

The Initial Public Offering (IPO Process)

The Initial Public Offering (IPO) is a process that is essentially 2 parts. It includes the activity before the initial offering and the IPO itself. This ensures that things proceed smoothly and all the steps in the process are followed to limit risk. The activities for an IPO include:

  • Receiving proposals – investment bank/underwriter offers a prospectus on their services and discusses offer pricing, number of shares, and estimated time frame.
  • Choosing an underwriter/investment banker – to assist in preparing for the IPO, which can take as long as 6 to 9 months. When looking for an investment banker, it’s important to research several factors that include:
  1. Industry expertise
  2. Reputation
  3. IPO track record
  4. Investor reach
  • Document filings and due diligence – research is conducted on the company and its management to avoid unexpected issues affecting the IPO launch or pricing. Contracts will be signed that explain services provided and may include 1 or more of the following agreements.
  1. Firm commitment – the underwriter agrees to buy the IPO and resell its shares to the public, guaranteeing the company will receive the amount of money listed in the agreement.
  2. Best effort – the underwriter agrees to make their best effort to sell the shares, but no guarantee is made that they will sell.
  3. All or none – either the underwriter sells all shares or the IPO is canceled.
  • Registration – underwriters will begin registering the IPO with the Securities and Exchange Commission (SEC) and may include documents such as:
  1. Letter of intent – gives the scope of obligations and commitment to the issuing company and the company’s statement to cooperate with the underwriter and provides a 15% over-allotment option.
  2. Engagement letter – includes a clause that the company will pay all out-of-pocket expenses the underwriter incurs and includes the underwriter’s fee.
  3. Red herring document – includes the information about the company’s operations.
  4. S-1 registration statement – submitted to the SEC to register the IPO. It includes all relevant information about the company and its finances with additional details not available to the public.
  • Marketing the IPO – underwriters start marketing the new stock offering to establish demand and prepare for the roadshow. This is the company’s opportunity to travel around to measure demand for shares to help underwriters set the final share price and the number of shares to make available.
  • Pricing the IPO – Once approved by SEC, underwriters set a share price which can be determined by factors such as outcomes from the roadshow, anticipated demand, company valuation, and reputation. This is a crucial step since too high of a price can deter investors, while too low of a price and the company won’t reach its financial goals.
  • Launch and shares issued – the company issues the shares and receives funds paid by investors who have purchased the shares. It’s recorded on the stockholder’s balance sheet.
  • Direct listing vs. IPO – a direct listing public offering is similar to an IPO but eliminates the intermediaries such as banks, underwriters, and brokers and underwrites their own securities.

The benefits and risks of IPOs

There are many reasons why a company may decide to go public, but not all of them may be right for every company, so it’s essential to be aware of the disadvantages as well as the advantages.

The Benefits of IPOs

These are the main advantages of an IPO

  • Fundraising opportunities – One of the most popular reasons to have an initial public offering (IPO) is to raise funds for research, hire employees, reduce debts, build facilities, and promote overall growth. The ability to raise money can significantly impact a company’s success.
  • Reduce the cost of borrowing – Private companies don’t get any benefits when it comes to borrowing money. High-interest rates and difficulties in getting loans can make starting and running a business complex at best. An IPO can alleviate the problem because the company is viewed as less risky and creditworthy. Those factors, along with the ability to attract investors, can make a big difference for a company.
  • Opportunity for early investors to liquidate – Early investors in a company don’t always intend to stay for the long run, and an IPO offers them the opportunity to liquidate their investments and move on.
  • IPOs offer publicity – An IPO can provide significant exposure to the customer base that the company serves, providing a way to gain attention, credibility, and growth.
  • IPOs can attract top talent – The ability to offer stock options as part of a recruiting package is a valuable way to attract top talent to a company, which can often bring it to the next level.

The risks of IPOs

These are the main disadvantages of an IPO

  • Regulation requirements and disclosures – Going public with an initial public offering means the company is required to provide a variety of information, including financial statements, to the SEC yearly. It can be a tedious and lengthy process that can put strict financial controls on the company. Document preparation fees and audits can cost the company significant amounts of money.
  • Giving up control – Although the company may have already been a success, an IPO means goals need to be met, and shareholders need to be happy. The IPO provides needed cash, but it comes with expectations. In some cases, the IPO may give control to shareholders, without any choice in doing so for the owners, even if they disagree with the company’s direction.
  • Pressure to perform – Company founders usually have a vision for their company and its growth, but an IPO and the restrictions it comes with can derail that vision. The public view can be turned upside down as investors and analysts pressure them to meet earnings targets. The failure to meet goals can disrupt leadership and operations in an effort to meet those goals.
  • Expenses – Going from a private to a public company with an IPO is expensive. Between document preparation costs, underwriting and regulation costs, legal fees, and advisors who make it all happen, it can add up fast.

How to gain access to IPO stocks

Why invest in IPOs? There are various reasons why investing in IPOs can be advantageous. One reason is the ability to invest in a company you believe in that offers the products and services that can benefit the public. Investing can be done during regular stock market hours between 9:30 a.m. – 4:00 p.m. EST. However, trading for an IPO typically does not begin until the late morning or early afternoon of the first trading day. This delay may be caused by limited share supply and high demand.

Other reasons include:

  • Ground floor opportunity – When you invest in a company with high growth potential, they may offer better returns over time if the company does well, but it’s always a risk. All investing has uncertainties, so being aware of them is important.
  • Transparency – An IPO goes through a highly regulated process, and the information is available for all investors, big and small.

When it comes to how to buy IPO stock, there’s a process. Although we’d like to think we can just go online and buy an IPO stock, it isn’t that easy. The first step is finding a brokerage firm that handles IPO ordering, as not every firm has the ability to do so.

Even if you can buy, you may not be able to get the initial offering price, and there may also be requirements that must be met before you’re eligible to buy.

So what can you do to get around the hurdles? One option is to check out exchange-traded funds (ETFs) that invest in IPOs, referred to as IPO ETFs, which offer access to newly public companies.

The bottom line

IPOs can make a big difference for private companies when raising the money they need to grow. The process isn’t easy, though, and it’s expensive and time consuming. But it does offer the opportunity to raise funds and shine a spotlight on the company.

Investors like the idea of investing in IPOs due to the potential gains, but it’s not easy to get in on the ground floor as not all brokers offer them. Even if it’s possible, they can be risky.

You don’t need to invest in IPOs to get started creating your own portfolio. Public offers a variety of investments, and the Public app keeps everything at your fingertips for easy access to all your investments at a glance. Ready to get started? Download the Public app today!

Rachel Curry is Pennsylvania-based content writer and journalist talking all things finance. She likes to give meaning to numbers by humanizing them. You can connect with her on Twitter at @writingsofrach.

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