IPOs Explained: How They Work and If They’re a Good Fit For You

Introduction

An initial public offering (IPO) refers to the first time a privately owned company decides to offer its shares to the public. After this process, popularly known as “going public”, the shares become available to be traded in the stock market.

Though it’s a lengthy and bureaucratic process, there are many reasons why a private business can decide it’s time to go public. For investors, buying IPOs at the right time can be a unique chance to invest in a growing lucrative business right at the start, gaining major profits if the business grows as expected.

However, IPOs also involve larger risks, since they are investments in new companies that are just now entering the market. Without previous history and price analysis, it comes down to research and strong beliefs that the investment will be worth it.

In this article you’ll learn more about the IPO process, why companies go public, and if you should consider this type of investment for your financial goals.

What is an IPO?

When a private company decides it’s time to offer its shares to the general public, it goes through the process of doing an initial public offering (IPO). An IPO is a complex and multifaceted process that involves not only the company and potential investors but also investment banks and regulatory bodies. This is not the only way a company can go public, as you’ll see later in this article, but it is the most traditional way to do so.

When a company is private, the only shareholders are the founders, initial investors, venture capitalists, maybe friends and family, and insiders in general. Everything is still controlled within the ecosystem of the company, with little to no control exerted by others.

When a company goes public, as the expression suggests, the general public will now be able to enter the world of the company: invest in it, benefit from its growth, and maybe influence its decisions. This is the only reason people will buy shares of a company.

How does the IPO process work?

When a company decides to do an IPO, it needs to be prepared for a long and complicated journey, full of details and paperwork, and involving multiple people. Listed below are the main steps to take:

1. Decision and pre-IPO preparations. The founders, executives, and other company decision makers decide it’s beneficial to do an IPO. Then it’s time to carefully analyze the financial documentation and get key employees to help, like upper management, accountants, lawyers, and specialists in finance regulation.

2. Underwriters selection. The company needs to choose one or more underwriters to help with the IPO process. Underwriters are investment banks with high expertise in every aspect of this operation, like pricing, documentation, filling regulations, marketing and finally selling the initial shares.

3. Due diligence and regulatory filings. The company needs to file an IPO application to the regulatory financial institution in their location. This is vital because all of the documents and information will be carefully analyzed and this will usually require a back-and-forth approach, with the company having to adapt to new evaluations.

For example, in the United States, the regulatory institution is the US Securities and Exchange Commission (SEC). In the United Kingdom, it’s the Financial Conduct Authority (FCA).

1. Marketing and roadshows. The underwriters begin advertising the business to potential investors, especially bigger and institutional ones, doing what is commonly known as roadshows. Based on apparent interest, they start discussing the potential ideal price for the initial shares.

2. Pricing and allocation: After careful analysis and based on the interest shown by major investors, the underwriters decide on the initial price and allocate shares to the selected institutional and retail investors. This price is usually smaller than the final price on IPO launch day.

3. IPO launch and afterwards: On the scheduled day, the company finally goes public and the shares start being traded on a stock exchange. After that, it will be mandatory for the business to disclose its financial information, usually with quarterly and annual reports.

Why do companies go public?

If it’s so complicated to become a publicly listed company, why do companies do this? There are many strategic reasons. Some of the main ones are listed below:

1. Capital generation. Going public is an important way to generate a significant amount of capital from a large number of investors. The raised money can be used to grow the company, pay debt, create new products, or fund research and other strategic endeavors.

2. Easier liquidity. When a company goes public, it can be an exit strategy for founders, early investors, and employees. It’s a good opportunity to sell their shares and get the returns on their investment, especially if the IPO is successful and the shares are higher in value.

3. More visibility. You probably have seen a lot of buzz and news coverage when a company decides to go public. This is especially true of “hyped” companies. Going public generates lots of free marketing and can enhance the perceived reputation of the company, making the business seem more credible and profitable.

4. Talent attraction. A public company might offer its shares to attract highly requested employees as a form of compensation. Together with a good salary, stock packages can be a powerful way to retain the highest performers of the company. If the company grows and its shares are valued more, the employees will benefit from it.

5. Financial options. Stocks can be used as a form of currency to facilitate merging with or acquiring new companies. Public companies also benefit from lower interest rates and usually better loan terms, since they are more transparent with their numbers. More shares can also be issued to generate more capital.

Challenges and risks of going public

The benefits of going public for a company are many, but the drawbacks should also be considered with caution and attention. After an IPO process, the business will undergo drastic changes in its management and planning procedures. Here are some of the main challenges that a public company will encounter while going public and after:

1. High costs. It’s no secret that an IPO will cost the business time and money, and many of these costs won’t stop after the company is available in the market. Underwriting expenses, legal paperwork, and extra accounting work — all that can have high costs, and these factors should always be considered in the IPO planning.

2. Management focus. With extra eyes on the company, as well as investor and media scrutiny, upper management can have trouble focusing on their core business, instead stretching itself too thin managing all of the multiple important factors for a successful IPO launch and after launch.

3. Less control. Depending on the type of shares sold in the market, the new shareholders will have more power influencing the company’s decisions. This can be challenging for the current directors and even the founders, who aren’t accustomed to that way of doing business.

4. More regulations. A publicly traded company has to comply with lots of rules, reporting frequency, and transparency requirements. Not only before the IPO launch but especially after, the business needs to provide quarterly and annual financial reports, with lots of eyes checking those documents and information.

5. Price volatility. The market can be unforgiving and everything related to the company, including news and rumors, can affect the share price drastically and fast. Management has to adapt to this new reality and be able to deal with the extra pressure, especially when it comes to growth expectations.

6. Initial restrictions. Founders, employees, and other insiders won’t be able to sell their shares immediately after the IPO. This lock-up period will last up to 180 days and is meant to protect the share price from falling too rapidly. After the lock-up period ends, this can change very fast, leading to volatility that can harm the company.

In short, an IPO can help a company grow immensely, both in financial and credibility terms. However, the risks are always there and it’s essential that underwriters and managers proactively apply strategies to minimize their consequences.

Different ways to go public

The IPO process with underwriters is the standard way of going public, but there are different options a company can consider. Since the underwriter route is expensive and potentially more complicated, some businesses might decide on a different approach.

One of these options is a direct listing where a company offers its shares directly on a stock exchange, without underwriters. This way there are no underwriting costs, but it can also mean the shares will suffer more price volatility because of less control and lack of a set price. Also, no new capital will be generated since there are no new shares being created and sold.

Another option is a Dutch auction, where essentially there is no predetermined price. Interested buyers will place bids and the final price will be determined by investors and demand. As with any auction, the buyers that suggest the highest prices will get the allocated shares.

Lastly, there is the SPAC (Special Purpose Acquisition Company) option. This method requires a shell public company that only exists to buy a private company. When this merger happens, the private company automatically becomes public, bypassing the IPO. This is a faster and easier process than doing a traditional IPO, but nowadays the market is skeptical about the validity of SPACs and their success after the merger.

How to invest in an IPO

It can be hard for common investors to get access to new IPOs right at the beginning. Since underwriters usually choose institutional investors, most of the shares will already be allocated before the company even goes public.

However, interested investors can follow news to be aware of upcoming IPOs and also check with their brokerage if there will be any new IPOs available in the near future.

Another important factor before even considering investing in IPOs is recognizing that they are volatile and usually speculative investments. This makes it even more crucial to get your information from multiple sources, not only from the company disclosed documentation.

Pros and cons of investing in an IPO

There are lots of factors to consider before deciding whether IPOs are good for your financial goals. Check out the table below for important strengths and weaknesses to keep in mind:

When it comes to IPOs, researching and doing your homework can really mean the difference between choosing the right or wrong option. Always remember to carefully read the company applications and to do your own research on the business and the market where it operates.

Summary

An initial public offering (IPO) is when a private company decides to offer its shares to be traded on the stock market. There are many reasons a private business can decide to go public, such as raising capital and increasing its reputation.

For investors, IPOs can be an interesting opportunity to invest in growing businesses right at the start, potentially guaranteeing more returns over time. However, there are also greater risks associated with IPOs and each investor should do their own research before committing to a new listed company.