What is an Initial Public Offering (IPO)?

Thursday, September 27, 2018 | MarketBeat Staff
What is an Initial Public Offering (IPO)?

In the go-go days of the late 20thcentury, the dream of a generation of tech startup companies was to get big enough to either be bought out by a large company or attract enough interest from investors to undertake an initial public offering. In some cases, the founders were visionaries who, upon starting the business, had no interest in running a massive corporation, and were looking for an exit strategy that would allow them to sell and move on to the next thing.

In other cases, the company wanted the prestige and the credibility that came from being listed on a major exchange. It doesn't hurt that initial public offerings have a way of creating millionaires and billionaires. Think Mark Zuckerburg who took Facebook public in 2012 to the tune of over $16 billion. And that isn't the largest IPO. That belongs to the Chinese company (and Amazon rival) Alibaba which conducted an IPO in 2014 that raised over $25 billion.

In this article, we'll review what an initial public offering is and why companies will issue them. We'll go over the pros and the cons of IPOs and define the process in detail. We'll conclude by describing why it is difficult, though not impossible, for an individual investor to take part in an IPO and why not being able to participate may actually be a good thing.

What is an Initial Public Offering (IPO)?

An Initial Public Offering (IPO) is a formal process in which a previously private company for the first time raises money through the sale of shares to institutional (and on rare occasions) retail investors on a major stock exchange. When a company issues an IPO, the company is said to be “going public”.

Why does a company issue an IPO?

The financing for a startup company comes from personal funds provided by the founders or owners and is frequently supplemented by business loans or through money provided by venture capitalists or angel investors. But the pool of investors is small, and there frequently comes a point where a company needs to raise a large sum of money in order to achieve the type of growth that they desire.

In some cases, an IPO is issued as part of an exit strategy for the founders who may want to retire or to step away from the day-to-day operations of the business, and want to profit from the initial investment that they’ve made in the business.

What are the pros and cons of an IPO?

The pros:

  • The company maximizes the amount of capital it can raise compared to their options as a public company.
  • They gain access to a large and diverse investor group.
  • Going public is usually a sign of financial health which can give the company a lower cost of capital.
  • Typically a company that goes public will gain marketing exposure which can create a short-term bump in both sales and profits.
  • As a public company, they can use incentives such as stock options to attract management talent and skilled employees.
  • An IPO can be used to facilitate an acquisition

The cons:

  • The company will now have to disclose information about their business as a matter of public record including earnings reports, balance sheets, and tax information.
  • They will have to absorb ongoing legal, marketing, and accounting costs that are required of a publicly traded company. Many of these can be significant.
  • Their management team will have to dedicate the necessary time and attention to accurate reporting.
  • The risk of the stock price going lower after the offering (i.e. the required funding will not be raised because the market does not accept the price).
  • Competitors, suppliers, and customers will now have transparency in your financial information.
  • A group of new shareholders with voting rights who could theoretically control company decisions through the board of directors.
  • A presumption of risk from legal or regulatory issues such as class action lawsuits and other shareholder actions.

An initial public offering is a lengthy process

Once a company has made the decision to go public, there is a formal underwriting process that they have to undertake. This is because the company can’t simply sell their private shares on an open market. They need a broker of sorts to act as a go-between for the company and the market. Investment banks such as Goldman Sachs Group, Credit Suisse Group, Morgan Stanley and Merrill Lynch, are invited in to conduct the IPO.

But before the underwriting process takes place, the company has to take another critical step. They must identify and/or hire a management team that is prepared and capable of addressing all the new issues that come with taking a company public such as:

  • Understanding how the company’s business will change as a public company and be able to steer it towards growth.
  • Obtaining financial statements that are audited using IPO-accepted accounting principles.
  • Putting in place defenses for the company against possible takeover attempts.
  • Developing sound corporate governance including establishing an independent board of directors and qualified officers
  • Timing the IPO during a time of favorable economic growth

Once the management team is in place, the company can begin the underwriting process. As mentioned above, this starts by bringing in an investment bank who will work with the company to review the details of the underwriting agreement such as the amount of money the company is looking to raise and the type of securities that will be issued. With the details in place, the banks will make a proposal for how the IPO is funded. This is typically done in one of three ways.

  • In a firm commitment, the bank agrees to buy the entire offer itself and reselling the shares to the public. In this way, the bank is guaranteeing that a certain amount of money will be raised.
  • In a best efforts agreement, the bank will agree to sell securities for the company but does not issue a guarantee for the amount raised. This may be done when there is a concern that market conditions will not be favorable. In this case, an investment bank looks to limit their risk, and potentially their profit by agreeing only to do their best to sell the shares but not guaranteeing a certain amount of shares be sold.
  • In some cases, an investment bank may not be willing to accept all the risk of an IPO. In this case, they may take the lead in the IPO, but reach out to other investment banks to form a syndicate of underwriters who will each sell a part of the IPO.

Now the filing process begins. The lead investment bank will file a registration statement with the SEC. At one time, the SEC required this document to provide a full disclosure of company data including financial statements, management backgrounds, any known legal problems, where the money from the IPO is going to be used, who in the company will hold stock in the new public company, down to the minor details of something like their proposed ticker symbol. Once the filing is submitted and the company waits for approval, the company and underwriting bank will put together a “road show” where they market the IPO to prospective investors to gauge interest.

Once the SEC approves the filing, the company and the bank set the “effective date” when the stock will be offered to the public as well as the initial price per share for the offering.

The length of time between the filing and the effective date used to take months but has been significantly shortened. In some cases, that process can now be as short as 50 days. That’s because of an Obama-era initiative that allowed companies to write “confidential IPO filings” was expanded in 2017 to be available to all companies regardless of size. In these filings, the company could put together a draft document, but not commit themselves to submit sensitive financial documents or other information which, once submitted with the filing, become a matter of public record and can be seen by competitors. Also, a confidential filing allows companies to take a more analytical approach to the roadshow and adjust their presentation in response to feedback they receive. Companies such as Snap, Shake Shack and Twitter are among the companies who have taken advantage of the ability to initiate a confidential filing.

Can individual investors take part in an IPO?

An individual public offering is offered to institutional investors. This is because the company that is issuing the IPO is looking for large amounts of capital, which requires the kind of capital that is typically reserved for large investment banks. In very rare cases, if an individual investor is a client of an investment bank, and has the financial resources to do so, they may be invited to participate in the IPO through their broker.  This, however, is fairly rare.

Frequently after a company’s IPO, the price per share of the now public company begins to increase as shares are available to be traded on a major stock exchange. This means that individual investors looking to jump in after the IPO will typically have to pay a higher price than the investors that took part in the initial public offering. However, this is not always the case. In some cases, the share price may go down after an initial public offering if analysts feel that the company is now overvalued. When this happens, the individual investors are exposed to less risk and may be able to buy shares at a discount to the IPO price.

The bottom line on initial public offerings (IPOs)

Initial public offerings (IPOs) are one of the easiest ways for a public company to gain access to a large amount of investor capital. The overall goal of an IPO is for the company to sell a large number of shares at above their market value, thus raising a lot of money for the company. The theory is that institutional investors will want to own a part of the company, and then individual investors will jump in on the secondary market once the company begins to be publicly traded.

However, when a company initially goes public, the owners and the company still retain a high percentage of stock, allowing them to continue to have influence on the company’s direction despite the influx of new shareholders who have voting rights.

The decision to go from public to private is not an easy one and will require a company to take on expenses due to increased regulatory requirements. For this reason, in recent years, some companies are holding back from issuing IPOs to ensure they have the required funds to absorb the additional regulatory costs.

In an effort to spur interest in IPOs, the process for going public has shortened considerably in the past few years, due to the ability of companies to issue “confidential IPOs”. This allows a company to prepare a draft document to the SEC while they attempt to gauge the interest of institutional investors. 

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