The basics of IPOs

An IPO, or initial public offering, is the first time that a privately held company sells shares to the public on a stock exchange.

Derek Silva

Derek Silva

Published May 15, 2019

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KEY TAKEAWAYS

  • An IPO is the first time that members of the public can buy shares of the issuing company's stock

  • Most people don’t have access to IPOs unless they have significant money to invest, but you can still invest right after the IPO

  • You can find new IPOs by searching financial news or through S-1 forms on the SEC website

  • Investing in an IPO isn’t still comes with risk and IPOs are not a guarantee for profit

An initial public offering, or IPO, is when a company first lists shares of its stock on a stock exchange — like the New York Stock Exchange (NYSE) or the Nasdaq — so that the general public has access to buy and sell the stock.

Many private corporations have stock, but only issue shares to employees or initial investors, like the company’s founders. A private company can decide at any time to “go public” and sell shares of its stock to the public, but each stock exchange will have certain listing requirements a company must meet to qualify, like having shares worth above a certain value.

A big reason that many companies choose tolaunch an IPO is because they can get an influx of cash from making their stock available to new investors. But launching an IPO means publicly revealing most of a company’s financial information to the Securities and Exchange Commission (SEC), which could open the company up to criticism.

Someone may look to invest in an IPO because their investment returns could grow as the company grows and becomes more valuable. An investor who purchases a significant portion of the company stock may even have the ability to vote on some of its business decisions, depending on the company’s ownership structure.

In this article:

Why do IPOs happen?

Initial public offerings are primarily a way for companies to raise money. This money may help the company to pay off its debts, or simply to fund future products and growth. An IPO can also benefit a company's early investors, such as angel investors, venture capitalists, and private equity firms. Many startups receive funding from these types of investors, who then earn a profit if the shares they own in the company become more valuable after a successful IPO.

An IPO may also benefit employees, since many private companies and startups now offer their employees stock options as a benefit. Employees who have stock options vested — meaning they have the right to sell their shares of the stock — may collect a profit from selling shares after an IPO.

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Who can invest in an IPO?

Most people cannot invest in an IPO. During the IPO process, institutional investors get first dibs and most or all of the IPO shares may be purchased by institutional investors before they become available to the general public. Institutional investors are investment banks and other very wealthy investors who can agree to buy a high volume of shares. When you see that a company has begun an IPO, you’re typically reading about large investment companies that already promised to buy a certain number of shares.

The average investor, called a retail investor, may not have access to the IPO shares at the actual initial public offering, having to buy shares from the institutional investors right after the IPO.

Institutional investors stand to make money because they pay a stock’s offer price, and then regular investors end up paying them the market price, which may have gone up or down since the IPO.

Should I invest in an IPO?

Investing in an IPO comes with risk, just like all other stock market investments. You should always make sure you’re comfortable taking on the risk from a potential investment before purchasing any stock.

IPOs generally aren’t a way to get rich quick, either. It is true that the stock of some companies will increase significantly from its IPO, but not all companies will become more valuable and even if they do, it may take decades.

Consider Apple as an example. Apple’s IPO share price was $22 and the value of a share surpassed $300 in 2020. But Apple’s stock price held largely constant for decades after its IPO and the increases in stock price didn’t come until the 2000s. So while you may have been able to make a profit by investing in Apple’s IPO, holding the stock for 25 years or more, and then selling it at a higher price, that’s not necessarily what most people would consider a successful get-rich-quick scheme.

If you’re unfamiliar with picking stocks or whether you should be investing in the first place, consider finding a financial advisor.

How to invest in IPO stock

For cases where individual investors do have access to an IPO, the first thing to do is create an account with a brokerage firm (broker) that gives you access to IPO stock. Not all brokers offer access to IPOs and some have additional eligibility requirements. For example, a broker may require you to have assets worth $250,000 or more in your account or they may require you to make a certain volume of trades per month to qualify.

Once you have an account, you need to put in the hard work of finding upcoming IPOs and studying company financials to understand which you may want to buy. In general, this is similar to the regular process of picking stocks. It’s important to read a company’s prospectus and look at any other financial information it has made public. You may need to contact the bank underwriting the IPO to get the prospectus.

To reiterate, you may not have access to an actual IPO unless you have significant money to invest. You can still buy stock right after the IPO, just as you would with any other stock.

How to find IPOs

Nowadays, there are multiple ways to find initial public offerings. Check financial news sites for upcoming offerings. Some websites also specialize in tracking IPOs. Websites of the major stock exchanges, like the NASDAQ and New York Stock Exchange (NYSE), also have information on forthcoming IPOs.

You can also go directly to the source and search the EDGAR database from the SEC. EDGAR allows you to search S-1 forms, which a company must file with if it plans to go public.

In some cases, the best way to get in on an IPO is to have a connection. For example, being a customer at a brokerage that’s underwriting an IPO may help you get you access. If there’s a company or startup whose stock you're interested in, but it isn’t publicly available, you may also be able to contact the company and purchase private shares.

An in-depth look at the IPO process

Companies usually want to be in a solid financial position before an IPO, but that doesn’t necessarily mean they have to be profitable. For example, Uber and Lyft, which both had an IPO in the first half of 2019, posted losses of $1.8 billion and $944 million, respectively, the year prior, according to their SEC filings. The company will need to attract investors, though, so it typically needs to show financial growth.

The process leading up to an IPO is long, commonly taking six months or more, and involves a few big steps:

  • Choosing an underwriter
  • Setting a stock price
  • Submitting financial statements to the SEC for approval

Underwriting due diligence

All companies need an investment bank or other financial firm to underwrite its IPO. The underwriter of an IPO is a bank that will buy all the company’s shares at a discount and then resell them. The underwriter makes a profit on the price difference as well as from an underwriting fee.

Underwriting involves the underwriter looking through a company’s financials or other relevant information to confirm that it feels comfortable purchasing the company’s stock. The underwriting due diligence for an IPO is distinct — though similar — to what you’d go through for life insurance or mortgage underwriting.

Determining IPO stock price

A company and its underwriters decide how many shares to issue and how much each share is worth. How to price stock is an important decision for a company. The company will want to raise as much capital as possible from an IPO but it can’t price shares so high that it drives away potential buyers, or so low that the underwriter loses money.

Factors that may influence an IPO price include

  • A company’s current financial situation
  • A company’s prospects of future growth
  • How similar companies have priced their stock
  • Public demand for the company’s stock
  • Nonfinancial factors, like the company’s or CEO’s public image

The amount of stock a company ultimately decides to make available to public investors is called its shares outstanding and the shares outstanding are reported to the public. Apple, for example, has about 4.33 billion shares outstanding, as of the first quarter of 2020.

Filing with the SEC

Companies need to file many letters, statements, and documents with the SEC. Two important documents are the prospectus and Form S-1.

A red herring prospectus, or simply prospectus, goes into detail about the company, including its business model, key employees, and several years’ worth of financial information. (The red herring prospectus is called that because of a bit of red text toward the beginning of the document that explains that the document is incomplete and could be updated. Incomplete information can include shares outstanding or other financial figures.)

A separate document called a Form S-1 summarizes the information in the prospectus. Members of the public can also look up the S-1 forms of any public company and any company with an upcoming IPO through the SEC’s online EDGAR database.

Allocating stock shares to institutional investors

A company will shop around its prospectus to institutional investors, like investment banks and very wealthy individuals, to entice them to invest. Then underwriters will allocate shares to investors who expressed interest. An allocation is essentially a promise to sell the shares to these investors when the issuing company goes public.

What happens after an IPO?

The influx of cash that companies receive for an IPO comes when the underwriter initially buys their stock. After the company’s IPO, day-to-day fluctuations in the stock price don’t directly impact it. If stock prices go down after the IPO, it’s the individual investors who lose money. Underwriters could also lose money from an undersubscribed IPO, meaning that not enough shares are purchased by investors to offset what the underwriter paid the company.

If a company needs more capital, it could release a secondary offering in the future to receive another influx of cash at the high share price. Very successful companies may even repurchase their own shares through a stock buyback, also called a stock repurchase. A buyback is usually a way for a company to stabilize or increase its stock price.

Lockup period

Key stakeholders, such as the issuing company’s directors and executive officers, usually agree to a lockup period immediately following the IPO. During this time, which may also be called a lock-in period, these executive-level employees are prohibited from selling or transferring their stock.

Typical lockup periods may last between three to six months. This helps the stock price stabilize, as a lot of executives selling their stock right away could cause the price to drop.

Do investors own the company?

In most cases, an IPO won’t result in changes to the company’s ownership structure. The company’s owners or board of directors will generally withhold at least 51% of the company’s shares from the public in order to keep a majority stake in the company. The company may also classify some types of shares as having more voting rights (decision-making powers) than others.

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About the author

Personal Finance Expert

Derek Silva

Personal Finance Expert

Derek is a tax expert at Policygenius in New York City. He has written about multiple personal finance topics in the past, and his work has been covered by Yahoo Finance, MSN, Business Insider and CNBC.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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