Forbes Advisor- An IPO is an initial public offering. In an IPO, a privately owned company lists its shares on a stock exchange, making them available for purchase by the general public.
Many people think of IPOs as big money-making opportunities—high-profile companies grab headlines with huge share price gains when they go public. But while they’re undeniably trendy, you need to understand that IPOs are very risky investments, delivering inconsistent returns over the longer term.
How Does an IPO Work?
Going public is a challenging, time-consuming process that’s difficult for most companies to navigate alone. A private company planning an IPO needs not only to prepare itself for an exponential increase in public scrutiny, but it also has to file a ton of paperwork and financial disclosures to meet the requirements of the Securities and Exchange Commission (SEC), which oversees public companies.
That’s why a private company that plans to go public hires an underwriter, usually an investment bank, to consult on the IPO and help it set an initial price for the offering. Underwriters help management prepare for an IPO, creating key documents for investors and scheduling meetings with potential investors, called roadshows.
“The underwriter puts together a syndicate of investment banking firms to ensure widespread distribution of the new IPO shares,” says Robert R. Johnson, Ph.D., chartered financial analyst (CFA) and professor of finance at the Heider College of Business at Creighton University. “Each investment banking firm in the syndicate will be responsible for distributing a portion of the shares.”
Once the company and its advisors have set an initial price for the IPO, the underwriter issues shares to investors and the company’s stock begins trading on a public stock exchange, like the New York Stock Exchange (NYSE) or the Nasdaq.
Why Do an IPO?
An IPO may be the first time the general public can buy shares in a company, but it’s important to understand that one of the purposes of an initial public offering is to let early investors in the company cash out their investments.
Think of an IPO as the end of one stage in a company’s life-cycle and the beginning of another—many of the original investors want to sell their stakes in a new venture or a start-up. Alternatively, investors in more established private companies that are going public also may want the opportunity to sell some or all of their shares
“The reality is that there’s a friends and family round, and there are some angel investors who came in first,” says Matt Chancey, a certified financial planner (CFP) in Tampa, Fla. “There’s a lot of private money—like Shark Tank-type money—that goes into a company before ultimately those companies go public.”
There are other reasons for a company to pursue an IPO, such as raising capital or boosting a company’s public profile:
- Companies can raise additional capital by selling shares to the public. The proceeds may be used to expand the business, fund research and development or pay off debt.
- Other avenues for raising capital, via venture capitalists, private investors or bank loans, may be too expensive.
- Going public in an IPO can provide companies with a huge amount of publicity.
- Companies may want the standing and gravitas that often come with being a public company, which may also help them secure better terms from lenders.
While going public might make it easier or cheaper for a company to raise capital, it complicates plenty of other matters. There are disclosure requirements, such as filing quarterly and annual financial reports. They must answer to shareholders, and there are reporting requirements for things like stock trading by senior executives or other moves, like selling assets or considering acquisitions.