What is an initial public offering?

Put simply, an IPO is a transition from a private company to a public company. From a company's point of view, they can raise additional capital by selling their shares to the public for future expansion. For investors, they can invest and share in the profits of publicly-traded companies.

If the IPO performs well in the market, it's a win-win situation for both parties. However, all investments involve risks, and stock issuance is no exception. Going public is alluring for many private companies because they can raise a lot of capital in the public market. 

How Do IPOs Work?

The concept of an IPO is relatively simple: a private company offers shares, or small pieces of ownership in the company, to the public. The public is then able to make money off the company’s future success, and the company has access to more money to grow and accomplish bigger goals.

While IPOs may be common for early-stage companies with high growth potential, that isn’t the only type of company that can go through an IPO. Lrge companies that underwent bankruptcy and have restructured or reorganised may re-enter the public market through an IPO.

While IPOs may be common for early-stage companies with high growth potential, that isn’t the only type of company that can go through an IPO.

Private companies wanting to go public typically find an investment bank to facilitate the process. This bank handles pricing estimates, roadshows, and paperwork, while consulting with management throughout the process. The company will also need to apply to be listed on public stock exchanges, such as the NASDAQ or the New York Stock Exchange (NYSE). 

What Is the IPO Process?

The steps for going from a private company to a public company include:

1. Finding an Underwriter or Investment Bank 

It is important to choose an investment banking company that has a good reputation and that can distribute the initial shares to the audience the company wants, such as institutional investors versus smaller or individual investors. 

2. Due Diligence and Filing 

The company and the investment bank agree on what type of underwriting they prefer. For example, an investment bank can agree to buy all of the shares of the company themselves and give the company an agreed-upon amount of money, or they can agree to try to sell as many shares as possible without any guarantee of how much the company will make.

3. Setting a Price 

The price of the IPO stock will be determined by the goals of the company, financial models of the company’s future growth and earnings, the condition of the economy, and how well the roadshows went. A roadshow is when the investment bank pitches the IPO to potential investors to gauge interest. 

4. Launching the IPO 

The SEC must approve an IPO before it can launch, but if the SEC gives its blessing and the company and investment bank have agreed to all the terms and share pricing, the company is ready to hit the market. Oftentimes, the IPO is announced in advance so investors know when to be ready to buy shares. 

5. Stabilising the Share Prices 

Although there are SEC restrictions on manipulating market prices of stocks, those rules are suspended for a 25-day period after the initial launch of the IPO. During this time, the investment bank is able to buy and sell shares to keep the price favourable for their client.

6. Competing in the Market

At this point, the private company is now considered fully public and the investment bank gives control of the share price over to the public market. While the bank may still work with the company as a consultant, the price of the stock now depends entirely on the market. 

Pros and Cons of IPOs

Ultimately, going public isn’t always right for every company. And there isn’t ever a requirement for a company to go public — a company can stay private indefinitely. 

Some advantages of an IPO include: 

• Big capital potential: While an IPO is expensive for the company initially, companies can make a lot of money from the public market. 

• Exposure: An IPO can involve a lot of interest in the future of the company, which may lead to more respect in its industry and better terms for future funding. 

• Allow early investors to cash in: A key reason some companies launch an IPO is because the early investors are ready to cash in on their investments.

Some downsides to going public include:

• Public companies have more transparency requirements: Once public, a company must disclose a lot of financial details to the public, including quarterly and annual financial statements.

• Some companies simply cannot qualify: Even if a company meets SEC requirements, it may not be able to find a bank willing to facilitate the process.

Key Takeaways

• IPO is a way of raising funds without a loan.

• An IPO is a company's transition to a publicly-traded stock.

• Due to limited public information, investing in an IPO may be risky.

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