IPO Explained: What Is an Initial Public Offering?

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When a private company decides to sell stock to the public, it holds an initial public offering or IPO. This marks the first time investors can buy shares, offering potential opportunities — but also risks.

Companies go public to raise capital, expand or build brand recognition. While IPOs can offer growth potential, early trading can be volatile, requiring investor patience. Read on to learn more.

What Is an IPO?

When a company first starts, it is typically owned by a few people. Usually, companies are either a single proprietorship, a partnership or a corporation. As a private company grows, the ownership may decide to go public.

It is helpful to understand what it means for a company to become an IPO and why a decision is made to go public. 

IPO Definition

An IPO stands for initial public offering. This essentially means a private company has gone public. It is the first time others can purchase company shares in the stock market. The company now has shareholders. 

Why Companies Go Public

There are various reasons a private company may choose to go public. Sometimes companies want to develop new products, or they may want to expand geographically and need additional capital to do so. 

Other reasons may include the following: 

• To allow owners and employees to 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.
• To raise capital and increase the opportunity for access to capital in the future.

Good To Know

A decision to go public signals that a company is mature and stable enough to move forward with a larger, more lucrative vision for the future.

This kind of confidence may fuel other investors to want to participate in the growth of the company.

Going public can increase brand recognition and market enthusiasm for the company. 

How Does the IPO Process Work?

The IPO process involves several steps. There are behind-the-scenes actions that need to occur before the first public offering takes place. Here’s a look at three phases of the offering: preparation, pricing and launching of the IPO. 

Preparing for an IPO

It takes multiple steps to prepare a private company to become an IPO. Those steps include the following: 

Underwriting 

• Underwriters propose that 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 to the open market.
• They’ll also weigh in on the timing of the IPO since market sentiment can often impact an IPO’s success.

Filing 

• 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.
• Potential investors will use this statement to make an informed decision about whether to invest and at what price.

Pricing the IPO

Market demand and the company’s valuation influence an IPO’s share price. 

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.

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.

Launching the IPO

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.

When the stock market opens and the 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.

Pros and Cons of IPOs for Companies

A private company going public is a big decision and has its advantages and disadvantages. If a company goes public, success is not guaranteed. It is important for a company to balance the pros and cons.

Benefits of Going Public

• Access to more capital. Companies that go public are able to access capital from the entire investing public. 
• Better visibility. Public companies can increase credibility and brand recognition, which could fuel goodwill from investors and the public. 
• Ability to attract more skilled workers. With stock compensation options, top talent may be incentivized to apply for positions in the company. 
• Lower cost of borrowing. A public company may receive more favorable loan terms.

Challenges of Going Public

• Loss of control. Key investors will have more say in the company’s decision-making. Control is not designated to one or two people as it may have been in a private company. 
• Stock volatility. Stock prices can go up and down based on market volatility. This may lead to a lack of stability in the company. 
• Significant costs. There are substantially more legal, accounting and marketing costs involved in a public company. 
• Regulatory compliance. Public companies are regulated by the SEC and have to disclose financial details. These tasks can take time, effort and money for a new IPO.
• Meeting shareholder expectations. A company has to meet shareholder’s expectations, which may mean jockeying for short-term profits. 

Famous IPOs in History

You may have heard of famous IPOs. Companies like Facebook, Alibaba and Tesla were once private, but successfully became notable IPOs. 

Notable Examples

• Tesla. Tesla went public in 2010 and proved to be a game-changer in the electric vehicle industry. The initial offering was 13,300,000 at a price of $17 a share.
• Facebook. One of the largest tech IPOs, Facebook, went public in 2012. The initial price offering was $38 per share. It had a slow start, but is now one of the most profitable companies in the world.
• Alibaba. A record-breaking IPO at the time, Alibaba, was one of the largest IPOs at the time in 2014. Alibaba launched an e-commerce and cloud computing company in China.

There are a few key lessons to learn from successful IPOs. These IPOs tend to be disrupters of their respective industry. In addition, these IPOs focus and pay attention to consumer demand. Successful IPOs also capture market trends and have a clear vision of innovation. 

Final Take 

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 newly public company, 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.

Karen Doyle contributed to the reporting for this article.

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