What is an IPO?

An IPO is more than an acronym. Initial public offerings help companies grow through financial support from the public, but that’s just the start of things. Here are all the defining details on what an IPO is, the IPO process and how IPOs work — for both the company and its investors.

TL;DR:

  • An IPO is the first time a company sells stocks to the public. It’s a process that can take months, and it comes with a lot of paperwork.
  • Investment banks serve as underwriters who set the price of an IPO. They also advise and fund companies as they proceed through the IPO process.
  • Underwriters also help propel the IPO roadshow, AKA finding interested investors early on.
  • Investing in an IPO can be quite risky. For investors considering an IPO, use the prospectus and other materials to find out why a company wants to go public and if it’s a sound choice. The IPO seller’s word may be biased, so hold a healthy dose of skepticism.

An IPO, defined

A privately held company that wants to go public ultimately sells stocks to outside investors. This means founders forgo a portion of ownership. In the past, private investors may have given them funding, but an IPO — or initial public offering — is the first time a company sells stocks to the public.

Despite this simple explanation, the IPO process can take months — sometimes up to nine months — and cost a pretty penny. This is because of the US Securities and Exchange Commission (SEC), who requires extremely thorough registration and reporting for all publicly traded companies. Companies who are transitioning from private to public have a lot of work to do. Among other things, they must have accounting data at the ready in case they’re audited by the SEC.

Who sets an IPO price?

We’re talking about the first stocks a budding publicly traded company sells. So who sets these prices? An investment bank.

When going public, a company hires an investment bank (or multiple banks) to “underwrite” their IPO. In this case, underwriting is just a fancy term for advising and funding a company’s IPO. The investment bank determines a valuation for the company and sets an initial stock price. They also help the company maneuver through the SEC’s strict IPO process.

When looking at how IPOs work, you want to understand the different ways investment banks will position themselves for their soon-to-be publicly traded clients. There are two main standpoints that underwriters take here:

 

  • Firm Commitment: This is when the investment bank guarantees the IPO by buying out the company’s full offering. They sell the individual stocks to the public themselves at a higher value for profit.
  • Best Efforts Agreement: The investment bank works with the company to help them sell the IPO shares. There’s no guarantee that the company will sell the entire offering, but they’ll try their best, hence the name best efforts.

 

How the IPO roadshow works

Investment banks that work as an underwriter for companies moving through the IPO process do more than just funding. They also help garner interest in the IPO, otherwise known as the IPO roadshow.

There’s no platform that curates all the upcoming IPOs (though you can find them by searching through the SEC’s latest S-1 filings to find companies on the verge of going public). Because of this, underwriters will approach potential investors to develop interest and make the IPO as successful as possible for the company and, of course, themselves.

Reasons companies go public

When it comes down to it, there’s one real reason why companies go through the IPO process to go public: to gain capital. But the reason they want money can differ:

  • A company may want capital to help grow their business through marketing, expansion and research & development. 
  • Alternatively, a company may want to use that capital to pay off existing debt or buy equity from private investors.

Not all companies decide to go public (less than 1% of all US firms are public, according to the National Bureau of Economic Research). Those that do wait months to years after opening before doing so. For many, strict SEC reporting guidelines are a deterrent, but capital from shareholders is often the deciding factor — whatever the purpose for those funds may be.

The good and the bad of investing in an IPO

For the common investor, investing in an IPO is one of the riskier stock market ventures. There’s a chance you’ll get major gains, and many people do. If a stock ends up excelling, early investors reap the greatest reward.

But because a company who wants to go public is seeking capital, they tend to start the IPO process when their performance is up. Moreover, IPO stocks have a tendency to swing strongly. What starts as a high-value IPO oftentimes dips down into negative territory. This is something that IPO investors should consider before diving in. It’s also why many experts (including Warren Buffet’s mentor Benjamin Graham, who jokingly said IPO stands for It’s Probably Overpriced) recommend waiting a bit before investing in an IPO.

Keep in mind that many IPOs are only available to preferred shareholders. IPOs with a well-known underwriter are often more reliable, because those investment banks tend to be choosier with which companies they fund.

What’s a prospectus, and why should IPO investors care about it?

Once a company goes public, the public has access to quarterly earnings reports that tell them about the business’ economic standing over the last few months. But when a company is going through the IPO process to go public, all that potential shareholders have access to is something called a prospectus.

A prospectus is one document amidst the SEC registration whirlwind that the company must produce (with the help of their underwriter, of course). The company and underwriter share the prospectus with potential investors during the IPO roadshow around the same time that they set an official date for the IPO.

Like the earnings report and the SEC-backed Q-10 form that accompanies it, a prospectus details the economic standing of the company. But the difference is that it’s written entirely by the seller. It’s a good idea to take this biased document with a grain of salt while also recognizing the details.

You can use the prospectus to see if you can determine whether a company has a handle on their finances and wants capital to grow, or if they want capital to pay off debt or equity. The latter tends to be a red flag. As previously stated, the publicly available prospectus is a piece of marketing material, so it’s not the be-all-end-all.

Bottom line

An IPO, or initial public offering, is a company’s first move into the realm of publicly traded companies. The IPO process can be a long (and sometimes expensive) one, but it’s necessary if a company wants capital to grow. With the help of underwriters, companies gain interested investors that help propel them into the stock market exchange. For shareholders, investing in an IPO skews on the risky side, so do your due diligence by vetting the company through their prospectus and any other information you can get your hands on.

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.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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