What Is an Initial Public Offering? IPOs Explained and How To Invest

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When a privately-held company decides it wants to sell stock to the public, it holds an initial public offering or IPO. This marks the first time the company’s stock is available for sale to investors, and it can be a bellwether for the health of the company as far as investors are concerned. In other words, because investors actually set the value of the company by the amount they will pay for a share of its stock, they determine the value of the company.

Why Do Companies Have an IPO?

When a company is first started, it’s usually a sole proprietorship, a partnership or a corporation, with a limited number of owners. These owners may invest their own money in the company, or they may borrow money to fund the company.

As a company grows, it may require more money for, say, product development or to acquire another company. At this point, the founders of the company may decide to sell shares of the company on the open market, or “go public.”

A company may decide to go public for several reasons, including:

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  • To let owners and employees sell their stock more easily
  • To increase the company’s public image or brand awareness
  • To acquire other businesses in exchange for stock in the company
  • To provide stock or stock options to current or potential employees as a benefit
  • Raising capital and increase the opportunity for access to capital in the future

How Does an IPO Happen?

The process of bringing a company public is well regulated by the U.S. Securities and Exchange Commission, or SEC. Companies that want to go public need to have some help from other organizations and they have to go through a stringent process before they can start selling their stock on the stock exchange.

Here’s how it works:

1. Underwriting the Deal

When a company decides the time is right to “go public,” the company’s management consults with investment banks who will underwrite the deal. These banks, having been through lots of IPOs before, will give management an idea of how much they think shares of the company will bring on the open market. They’ll also weigh in on the timing of the IPO since market sentiment can often impact an IPO’s success.

2. Syndicate Is Formed

Next, a banking syndicate is formed. This group of institutions will share the costs to bring the IPO to market and will submit the necessary paperwork to financial regulators. Their first step is to draft an S-1 registration statement, which discloses pertinent information about the company that potential investors will need to know to make an informed decision about whether to invest and at what price.

3.  Pricing Risk

Then the underwriting begins. Just like an insurance underwriter, an investment underwriter determines how much risk investors are likely to see in the company, and then they price that risk. After some back-and-forth negotiation, this process results in the offering price for the IPO, which is the price at which the stock will first be offered for sale.

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The date for the offering is set. The opening price can change if conditions also change, up until the day before the offering. On that day, about 90% of the shares are allocated to institutional investors, leaving only about 10% for everybody else.

4. Shares Are Offered

Once the day of the IPO arrives, the shares are offered for trading at the price that was agreed upon by the company and the syndicate. But the minute that bell rings, the market takes over and shares will trade at the price investors are willing to pay for them. This can be considerably lower or higher than the IPO price, making IPO investing one of the riskiest kinds of investing.

How to Get In On IPO Action

IPOs get a lot of attention in the investing world, and some of them can be pretty exciting. But it’s very difficult for the average individual investor to get in on the action. Aside from the 90% of shares that are allocated to institutional investors, many brokers reserve any IPO shares they may have access to for their best, i.e., highest net worth, customers.

Good To Know

Some brokerage firms like E-Trade and Fidelity will allow individual investors access to some IPOs, but they may have a limit on the amount of assets you have to have with the company to qualify.

Renaissance Capital has two IPO exchange-traded funds which buy into U.S. and international IPOs respectively. By purchasing shares in one of these ETFs, you’re buying a basket of IPO stocks, which can also reduce your risk compared to buying a single stock’s IPO.

Another way to take advantage of IPOs is through a special purpose acquisition company. An SPAC is a company that has no products or services and no sales. Its purpose is to raise capital in order to go public itself and then buy a pre-IPO company.

Here’s how it works:

  1. A group of institutional investors forms a SPAC.
  2. It takes the SPAC public through an IPO with shares priced at $10.
  3. Investors buy the shares in the SPAC at the asking price, and later at market price after the IPO.
  4. The SPAC uses the capital it raised by selling the shares at the IPO to purchase a privately held company.
  5. The shareholders of the SPAC now own shares in the formerly private company, which is now public by virtue of being acquired by the SPAC.

The trick with a SPAC is that you don’t know which company the SPAC will acquire until after you’ve invested. When you buy shares in the SPAC, you’re betting that the founders of the SPAC will acquire a successful company and your shares will appreciate in value.

The Biggest IPOs in 2020

In 2020, there were a number of blockbuster IPOs. In total, up to Dec. 14, there were 1,291 IPOs worldwide, which raised a total of $331 billion.

Top Five IPOs in 2020:

  • Airbnb (ABNB) went public on Dec. 10, 2010, raising $3.51b. Shares were priced at $146 at the opening, and as of Feb. 19, 2021 were trading at $201.07.
  • DoorDash (DASH) raised $3.37b on Dec. 9, 2020. Shares, priced at $185 dropped in the first few days of trading, but have since risen to $205.97.
  • Snowflake (SNOW) went public on Sep. 16, 2020 and raised $3.36b. Shares, which began trading at $120, were trading at $290.00 as of Feb. 19, 2021.
  • Palantir (PLTR) raised $2.57b when it went public on Sep. 30, 2020. Shares began trading at $10 per share, and as of Feb. 19, 2021 were fetching $29.00.
  • Warner Music Group (WMG) raised $1.93b on June 3, 2020. Shares opened at $25 and were trading at $36.38 on Feb. 19, 2021.

Not every IPO makes money, however. ContextLogic, Inc. (WISH), parent company of online retailer Wish, went public on Dec. 16, 2020, with shares priced at $24. On the first day of trading, shares opened at $22.75 and by the end of the day the stock was trading at $20.05. As of Feb. 19, 2021, shares were still trading below the IPO price at $22.26.

Is Investing in an IPO a Good Idea?

Investing in IPOs is not for the faint of heart, nor is it for the novice investor. Since there’s no real way to know the true value of a company that is newly public, i.e., the price other investors are willing to pay for a share of its stock, you won’t know until the stock starts trading whether you’ve made the right decision or not.

However, if you’re an experienced investor with significant holdings, plus the connections to get in on IPO offerings before they hit the market, you may be able to make good money from these newly public companies.

Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

About the Author

Karen Doyle is a personal finance writer with over 20 years’ experience writing about investments, money management and financial planning. Her work has appeared on numerous news and finance websites including GOBankingRates, Yahoo! Finance, MSN, USA Today, CNBC, Equifax.com, and more.

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