What is an IPO? Can I invest in one?

An IPO, or initial public offering, is the first time that a privately held company becomes publicly traded.

Zack Sigel 1600

Zack Sigel

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

  • IPOs may increase the issuing company's working capital, but if it goes badly, the company may have trouble selling shares in the future

  • While most people can't participate in an IPO, they can buy the stock later at market rate

When a company is ready to go public, it launches an IPO. An IPO, or initial public offering, is the first time that a privately held company becomes publicly traded. The company becomes listed on a stock exchange, which means it issues a certain number of shares of its stock priced at the company’s initial valuation.

For a company launching an IPO, the benefits include a large influx of cash, which can help it expand its business operations and generate more revenue at a faster pace. Beyond revenue growth, companies that have a successful IPO gather prestige and positive news coverage.

Investors reap the rewards later down the line, when the shares they bought grow in value. Investors own a part of the company, and those who purchase enough of a company’s shares may even have the ability to vote on some of its business decisions, depending on the company’s ownership structure.

But going public can have downsides. To launch an IPO, a company needs to reveal virtually everything about its finances to the Securities and Exchange Commission (SEC). If investors have little faith in the company, the company’s stock price may drop, making it less likely that future investors will buy into the company.

In this article:

Why do IPOs happen?

Initial public offerings are a way for companies to raise capital, which leads to future growth. They can also help the company pay off its debt; often, the company is owned by private-equity firms, and the IPO allows those private-equity firms to exit their investment with a profit.

In some cases, IPOs can be beneficial for employees. Many companies offer stock options to their employees. If the employee’s options have vested — meaning that he or she has the right to sell their shares of the stock — then, during the IPO, he or she can collect a nice profit in addition to his or her usual income.

For that reason, company equity, or owning a part of the company in the form of stock options, can be an important incentive for prospective employees to work for that company.

In most cases, an IPO won’t result in changes to the company’s ownership structure. That’s because the company’s owners or board of directors generally withhold at least 51% of their 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 than others.

Who can invest during an IPO?

During the IPO process, not everyone is able to invest right off the bat. When you see that a company has begun an IPO, you’re typically reading about large investment companies who already promised to buy a certain number of charges.

These companies — as well as individuals with enormous amounts of money to invest — are called institutional investors.

In fact, the average investor probably won’t have access to the shares at the initial public offering. Most if not all the shares will have been bought by institutional investors before they even become available to individual investors.

But that means you can invest right afterward. Although the institutional investors may have bought up a substantial majority of stocks, you’re allowed to buy it from them, if they’re selling. Institutional investors pay the offer price, and individual investors pay the market price, which may have gone up or down since the IPO.

What happens during an IPO?

In order to launch an IPO, the company usually wants to be in a solid financial position, but it doesn’t necessarily have to be profitable. (Uber and Lyft, the rideshare companies, 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.) But the company needs to show growth and have an actionable business plan in order to attract investors.

The company will enlist the help of an investment bank to underwrite their IPO. Basically, this means the bank or banks will buy all the company’s shares at a discount and resell them. The underwriter makes a profit on the price difference as well as from underwriting fees it collects.

For larger IPOs, a group of investment banks come together to form an underwriting syndicate. Uber, for example, had over two dozen underwriters backing its IPO.

Determining the stock price

The underwriters and the company decide how many shares to issue and how much each share is worth. Companies are allowed to issue as many shares as they want, at any price they think is fair.

However, they have an interest in keeping prices in accordance with their value. If the price is too high, nobody will buy; if the price is too low, people will buy, but the underwriter could lose money.

The amount of stock available to buy is called shares outstanding, which is reported by the company. Apple, for example, has about 4.67 billion shares outstanding, as of its March 30th, 2019, quarterly financial report.

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Filing with the SEC

The underwriter works with the company to create a red herring prospectus, which goes into deep detail about the company. The prospectus describes the company, including information about its business model and key employees.

Perhaps most importantly, it includes several years’ worth of information about the company’s finances, which can help buyers make a guess at whether their shares will be profitable.

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 often includes shares outstanding and other financial figures.

The prospectus, plus a separate document called a Form S-1 that summarizes the information in the prospectus, are both filed with the SEC. The prospectus is shopped around to institutional investors on a “road show” so they can decide whether to invest.

Afterward, 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.

You can look up the prospectus of any company that has an upcoming IPO by searching the SEC’s website, as well as those for companies that have already gone public. Although you won’t be able to participate in the IPO unless you’re a high-volume trader, the prospectus can help you decide whether to buy stock in the company post-IPO.

After the IPO

An IPO can bring in a lot of cash for the company, increasing its working capital. But after the IPO, day-to-day fluctuations in the company’s stock price don’t directly impact it.

That’s because the cash influx was already completed when the underwriter bought the initial shares. If the stock prices goes down after that, then it’s the investors who lose money. Even the underwriters could lose money if not enough shares are bought, which means the IPO is undersubscribed.

But when the stock increases in value, it can bring prestige to the company. The company won’t see that increased value directly, but it could release a secondary offering in the future and receive another influx of cash at the high share price.

Very successful companies may even repurchase their own shares. This is called a buyback. With a buyback, companies can spend a lot of money now to earn a lot of money in the future as the stock they own continues to grow. The buyback itself can stabilize or increase the company’s share price, since the supply of shares on the market is decreased.

Once the company is listed on its stock exchange, investors can start trading its stocks.

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.

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