What Is an IPO? How an Initial Public Offering Works

Definition

An IPO, or initial public offering, is the term for the first time that a private company sells shares of its stock to the public on a stock exchange.

What Is an IPO?

An initial public offering (IPO) is the event in which a private company converts to a public company by offering for sale a portion of its ownership through newly issued shares, enabling public investors to purchase equity and allowing its stock to trade on a public exchange.

Beyond raising significant capital for growth or paying down debt, it gives founders, early backers, and employees a chance to realize gains on their investments.

But an IPO is a journey, not a switch. It typically begins with selecting an investment bank to underwrite the deal and assist with valuation. From there, companies undergo audits, prepare regulatory filings (such as the S-1 in the U.S.), refine financial forecasts and performance indicators, conduct one or more roadshows to drum up interest, set the final price, deal with lock-ups, quiet periods, and, hopefully, stabilization and growth after trading begins.

Key Takeaways

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.
Companies must meet requirements by exchanges and the Securities and Exchange Commission (SEC) to hold an IPO.
IPOs provide companies with an opportunity to obtain capital by offering shares through the primary market.
Companies hire investment banks to market, gauge demand, set the IPO price and date, and more.
An IPO can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment.

How an Initial Public Offering (IPO) Works

Before an IPO, a company is considered private. As a pre-IPO private company, the business has grown with a relatively small number of shareholders, including early investors like the founders, family, and friends, along with professional investors such as venture capitalists or angel investors.

An IPO is a big step for a company as it provides the company with access to raising a lot of money. This gives the company a greater ability to grow and expand. The increased transparency and share listing credibility can also be a factor in helping it obtain better terms when seeking borrowed funds as well.

When a company reaches a stage in its growth process where it believes it is mature enough for the rigors of SEC regulations, along with the benefits and responsibilities to public shareholders, it will begin to advertise its interest in going public.

Typically, this stage of growth will occur when a company has reached a private valuation of approximately $1 billion, also known as unicorn status. However, private companies at various valuations with strong fundamentals and proven profitability potential can also qualify for an IPO, depending on the market competition and their ability to meet listing requirements.

IPO shares of a company are priced through underwriting due diligence. When a company goes public, the previously owned private share ownership converts to public ownership, and the existing private shareholders’ shares become worth the public trading price. Share underwriting can also include special provisions for private to public share ownership.

Important

Generally, the transition from private to public is a key time for private investors to cash in and earn the returns they were expecting. Private shareholders may hold onto their shares in the public market or sell a portion or all of them for gains.

Meanwhile, the public market opens up a huge opportunity for millions of investors to buy shares in the company and contribute capital to the company’s shareholders' equity. The public consists of any individual or institutional investor who is interested in investing in the company.

Overall, the number of shares the company sells and the price at which shares sell are the determining factors for the company’s new shareholders' equity value. Shareholders' equity still represents shares owned by investors when it is both private and public, but with an IPO, the shareholders' equity increases significantly with cash from the primary issuance.

History of IPOs

The term initial public offering (IPO) has been a buzzword on Wall Street and among investors for decades. The Dutch are credited with conducting the first modern IPO by offering shares of the Dutch East India Company to the general public.

Since then, IPOs have been used as a way for companies to raise capital from public investors through the issuance of public share ownership.

Through the years, IPOs have been known for uptrends and downtrends in issuance. Individual sectors also experience uptrends and downtrends in issuance due to innovation and various other economic factors. Tech IPOs multiplied at the height of the dotcom boom as startups without revenues rushed to list themselves on the stock market.

The 2008 financial crisis resulted in a year with the fewest number of IPOs. After the recession following the 2008 financial crisis, IPOs ground to a halt, and for some years after, new listings were rare. More recently, much of the IPO buzz has moved to a focus on so-called unicorns—startup companies that have reached private valuations of more than $1 billion. Investors and the media heavily speculate on these companies and their decision to go public via an IPO or stay private.

What Is the IPO Process?

The IPO process essentially consists of two parts. The first is the pre-marketing phase of the offering, while the second is the initial public offering itself. When a company is interested in an IPO, it will advertise to underwriters by soliciting private bids or it can also make a public statement to generate interest.

The underwriters lead the IPO process and are chosen by the company. A company may choose one or several underwriters to manage different parts of the IPO process collaboratively. The underwriters are involved in every aspect of the IPO due diligence, document preparation, filing, marketing, and issuance.

Steps to an IPO

Proposals. Underwriters present proposals and valuations discussing their services, the best type of security to issue, offering price, amount of shares, and estimated time frame for the market offering.
Underwriter. The company chooses its underwriters and formally agrees to the underwriting terms through an underwriting agreement.
Team. IPO teams are formed comprising underwriters, lawyers, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) experts.
Documentation. Information regarding the company is compiled for the required IPO documentation. The S-1 Registration Statement is the primary IPO filing document. It has two parts—the prospectus and the privately held filing information. The S-1 includes preliminary information about the expected date of the filing. It will be revised often throughout the pre-IPO process. The included prospectus is also revised continuously.
Marketing & Updates. Marketing materials are created for pre-marketing of the new stock issuance. Underwriters and executives market the share issuance to estimate demand and establish a final offering price. Underwriters can make revisions to their financial analysis throughout the marketing process. This can include changing the IPO price or issuance date as they see fit. Companies take the necessary steps to meet specific public share offering requirements. Companies must adhere to both exchange listing requirements and SEC requirements for public companies.

Board & Processes. Form a board of directors and ensure processes for reporting auditable financial and accounting information every quarter, as well as governance disclosures.
Shares Issued. The company issues its shares on an IPO date. Capital from the primary issuance to shareholders is received as cash and recorded as stockholders' equity on the balance sheet. Subsequently, the balance sheet share value becomes dependent on the company’s stockholders' equity per share valuation comprehensively.
Post IPO. Some post-IPO provisions may be instituted. Underwriters may have a specified time frame to buy an additional amount of shares after the initial public offering (IPO) date. Meanwhile, certain investors may be subject to quiet periods.

Advantages and Disadvantages of an IPO

The primary objective of an IPO is to raise capital for a business. It can also come with other advantages as well as disadvantages.

Advantages

One of the key advantages is that the company gets access to investment from the entire investing public to raise capital. This facilitates easier acquisition deals (share conversions) and increases the company’s exposure, prestige, and public image, which can help the company’s sales and profits.

Increased transparency that comes with required quarterly reporting can usually help a company receive more favorable credit borrowing terms than a private company.

Disadvantages

Companies may confront several disadvantages to going public and potentially choose alternative strategies. Some of the major disadvantages include the fact that IPOs are expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business.

Fluctuations in a company's share price can be a distraction for management, which may be compensated and evaluated based on stock performance rather than real financial results. Additionally, the company is required to disclose financial, accounting, tax, and other business information. During these disclosures, it may have to publicly reveal secrets and business methods that could help competitors.

Rigid leadership and governance by the board of directors can make it more difficult to retain good managers willing to take risks. Remaining private is always an option. Instead of going public, companies may also solicit bids for a buyout. Additionally, companies may explore alternatives such as equity or debt financing from venture capitalists or angel investors, grants or other non-dilutive sources, Dutch auction or hybrid auction models, or crowdfunding or direct public offerings.

Pros

Can raise additional funds in the future through secondary offerings
Attracts and retains better management and skilled employees through liquid stock equity participation (e.g., ESOPs)
IPOs can give a company a lower cost of capital for both equity and debt

Cons

Significant legal, accounting, and marketing costs arise, many of which are ongoing
Increased time, effort, and attention required of management for reporting
There is a loss of control and stronger agency problems

IPO Alternatives

Direct Listing

A direct listing is when an IPO is conducted without any underwriters. Direct listings skip the underwriting process, which means the issuer has more risk if the offering does not do well, but issuers also may benefit from a higher share price. A direct offering is usually only feasible for a company with a well-known brand and an attractive business.

Dutch Auction

In a Dutch auction, an IPO price is not set. Potential buyers can bid for the shares they want and the price they are willing to pay. The bidders who were willing to pay the highest price are then allocated the shares available.

Investing in an IPO

When a company decides to raise money via an IPO, it is only after careful consideration and analysis that this particular exit strategy will maximize the returns of early investors and raise the most capital for the business. Therefore, when the IPO decision is reached, the prospects for future growth are likely to be high, and many public investors will line up to get their hands on some shares for the first time. IPOs are usually discounted to ensure sales, which makes them even more attractive, especially when they generate a lot of buyers from the primary issuance.

Initially, the price of the IPO is usually set by the underwriters through their pre-marketing process. At its core, the IPO price is based on the valuation of the company using fundamental techniques. The most common technique used is discounted cash flow, which is the net present value of the company’s expected future cash flows.

Underwriters and interested investors look at this value on a per-share basis. Other methods that may be used for setting the price include equity value, enterprise value, comparable firm adjustments, and more. The underwriters do factor in demand, but they also typically discount the price to ensure success on the IPO day.

It can be quite hard to analyze the fundamentals and technicals of an IPO issuance. Investors will watch news headlines, but the main source for information should be the prospectus, which is available as soon as the company files its S-1 Registration. The prospectus provides a lot of useful information. Investors should pay special attention to the management team and their commentary, as well as the quality of the underwriters and the specifics of the deal. Successful IPOs will typically be supported by big investment banks that can promote a new issue well.

Overall, the road to an IPO is a very long one. As such, public investors building interest can follow developing headlines and other information along the way to help supplement their assessment of the best and potential offering price.

The pre-marketing process typically includes demand from large private accredited investors and institutional investors, which heavily influence the IPO’s trading on its opening day. Investors in the public don’t become involved until the final offering day. All investors can participate, but individual investors specifically must have trading access in place. The most common way for an individual investor to get shares is to have an account with a brokerage platform that itself has received an allocation and wishes to share it with its clients.

Fast Fact

New IPOs often face more demand than available shares, so not every interested investor can buy in. You can try to participate through your brokerage, though access is sometimes reserved for top clients. Another option is investing through a mutual fund or other vehicle that targets IPOs.

Performance of IPOs

IPO returns can vary widely, and investors watch them closely. Some IPOs are overhyped by investment banks and stumble out of the gate, while others enjoy quick gains in early trading. Either way, buying shares at the IPO stage carries high risk for individual investors.

Several factors influence performance, including the company’s competitive landscape, whether its shares were overpriced or underpriced, and its lack of a public track record. Remember that the offering price you see before the IPO is typically reserved for institutional investors, employees, and eligible clients, and by the time you can buy, the price may already have shifted. Understanding lockup periods, waiting periods, and strategies like flipping can help you navigate IPO investing more effectively and decide how to track these stocks after they debut.

Lock-Up

If you look at the charts following many IPOs, you'll notice that after a few months, the stock takes a steep downturn. This is often because of the expiration of the lock-up period. When a company goes public, the underwriters make company insiders, such as officials and employees, sign a lock-up agreement.

Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period. The period can range anywhere from three to 24 months. Ninety days is the minimum period stated under Rule 144 (SEC law), but the lock-up specified by the underwriters can last much longer. The problem is, when lockups expire, all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.

Waiting Periods

Some investment banks include waiting periods in their offering terms. This sets aside some shares for purchase after a specific period. The price may increase if this allocation is bought by the underwriters and decrease if not.

Flipping

Flipping is the practice of reselling an IPO stock in the first few days to earn a quick profit. It is common when the stock is discounted and soars on its first day of trading.

Tracking IPO Stocks

Closely related to a traditional IPO is when an existing company spins off a part of the business as its standalone entity, creating tracking stocks. The rationale behind spin-offs and the creation of tracking stocks is that, in some cases, individual divisions of a company can be worth more separately than as a whole. For example, if a division has high growth potential but large current losses within an otherwise slowly growing company, it may be worthwhile to carve it out and keep the parent company as a large shareholder, then let it raise additional capital from an IPO.

From an investor’s perspective, these can be interesting IPO opportunities. In general, a spin-off of an existing company provides investors with a lot of information about the parent company and its stake in the divesting company. More information available for potential investors is usually better than less, so savvy investors may find good opportunities in this type of scenario. Spin-offs can usually experience less initial volatility because investors have more awareness.

Important

IPOs are known for having volatile opening day returns that can attract investors looking to benefit from the discounts involved. Over the long term, an IPO's price will settle into a steady value, which can be followed by traditional stock price metrics like moving averages. Investors who like the IPO opportunity but may not want to take the individual stock risk may look into managed funds focused on IPO universes. But also look out for so-called hot IPOs that could be more hype than anything else.

What Is the Purpose of an Initial Public Offering?

An IPO is essentially a fundraising method used by large companies, in which the company sells its shares to the public for the first time. Following an IPO, the company’s shares are traded on a stock exchange. Some of the main motivations for undertaking an IPO include: raising capital from the sale of the shares, providing liquidity to company founders and early investors, and taking advantage of a higher valuation.

Why Would a Company Do an IPO?

A company might want to do an IPO in order to raise capital to expand, fund new initiatives or research and development (R&D), or to pay off debt. Because it is raising money from the investing public, an IPO can increase the company’s prestige and public image, which can help the company get better terms from lenders as well as boost sales and profits. Another reason for doing an IPO is to allow early investors to sell some or all of their shares in the company.

Who Gets the Money From an IPO?

The company going public keeps most of the proceeds of the IPO, but some of it also goes to those who helped them with the IPO process, including investment banks, accountants, lawyers, and others. Early investors who sell some or all of their shares can also receive money from an IPO.

Is an IPO a Good Investment?

IPOs tend to garner a lot of media attention, some of which is deliberately cultivated by the company going public. Generally speaking, IPOs are popular among investors because they tend to produce volatile price movements on the day of the IPO and shortly thereafter. This can occasionally produce large gains, although it can also produce large losses. Ultimately, investors should judge each IPO according to the prospectus of the company going public, as well as their financial circumstances and risk tolerance.

How Is an IPO Priced?

When a company goes IPO, it needs to list an initial value for its new shares. This is done by the underwriting banks that will market the deal. In large part, the value of the company is established by the company's fundamentals and growth prospects. Because IPOs may be from relatively newer companies, they may not yet have a proven track record of profitability. Instead, comparables may be used. However, supply and demand for the IPO shares will also play a role on the days leading up to the IPO.

The Bottom Line

A company that has an IPO and transitions from being privately owned to being publicly owned is taking a giant step forward. The money it raises can help fuel its growth, pay off early investors and debt, and allow for investment in research and development. But for investors, the IPO is no guarantee of future success, and it may take many years for that investment to pay off.