What is an IPO?

January 24, 2022

2021 was a banner year for the IPO market, with 1,635 companies going public across the world by the third quarter—more than the year-end totals of 2018, 2019, and 2020. And with huge names set to IPO this year—the likes of Instacart, Stripe, Impossible Foods, Panera, and Discord—2022 is shaping up to be a banner year for IPOs as well.

But what is an initial public offering, and is it worth your investment dollars?

It all comes down to knowing what you’re signing up for. Here’s what investors should know before participating in an IPO.

What is an Initial Public Offering?

An initial public offering, or IPO, is the process of a private corporation offering ownership shares to the public. In plain English, it’s when a privately-owned company lists its shares on the stock exchange for the first time. And as you can guess, it’s more than a question of paperwork.

Before a company reaches the IPO stage, it is considered a privately owned company. This means that it has grown with the support of a small number of private shareholders, ranging from friends and family to venture capitalists and angel investors. Going public can be a big opportunity for those private investors, since it provides them a share premium. For public investors, it’s a chance to own stock in a private company for the first time.

Key IPO Terminology

Here’s the thing: IPOs are a highly regulated process, and not just any company can do it. A company must meet the SEC’s filing requirements before it can lawfully offer shares. As such, there’s a lot of terminology involved.

One of the basic concepts is common stock, which is a type of ownership share in a corporation which is traded on the stock exchange. These entitle shareholders to receive dividends (if the company pays them) and vote in company shareholder meetings. Part of common stock is the issue price, or offering price, which is the price at which each common stock is offered to the public.

When offered on the exchange in an IPO, common stock is grouped by lot size, which is the smallest number of shares you can bid for an IPO. There’s also a price band, which is the price range in which investors can bid on IPO shares. These are set by the company and the underwriter, the investment bank managing offerings for the company.

In order to file at all, a company must file a preliminary prospectus, the first draft of a registration statement which is filed prior to proceeding with an IPO. It includes key company information such as the business strategy, recent and historical financial statements, and company management.

How an IPO Works

As you can guess, going public isn’t simply a matter of a company deciding who it wants to sell shares to. For one thing, a company has to go through a mountain of paperwork and financial disclosures to meet SEC filing requirements. For another, going public means an exponential increase in public scrutiny.

Because of this, companies hire an underwriter to help guide them through the process. The underwriter helps prepare the company for an IPO, including meeting all legal requirements and cleaning house in preparation for public scrutiny. The underwriter also helps set IPO pricing through due diligence.

Basically, an IPO consists of two parts: the pre-marketing phase and the IPO itself.

When a company wants to IPO, it solicits bids from potential underwriters. Underwriters then present their proposals for the IPO, including an overview of their services and valuations, the right offering price and securities, and an estimated time frame.

Once the company chooses its underwriter and finalizes the underwriting agreement, an IPO team is formed. This consists of four parts:

  1. Underwriters
  2. Attorneys
  3. Certified public accountants
  4. SEC experts

This team works together to compile documentation in preparation for the IPO. The most important is the S-1 registration statement, which includes the preliminary prospectus and private filing information. In the meantime, the team also creates marketing materials for pre-marketing of the new stock, which can also be used to gauge interest and adjust issue prices if appropriate. A board of directors is formed if the company doesn’t already have one.

If everything proceeds according to plan, the company issues public shares on the IPO date. Capital from the primary issuance is then recorded on the balance sheet as shareholders’ equity, and share value becomes dependent on stockholders’ equity per share valuation.

Why Companies Have IPOs

Most companies have IPOs for two reasons: to raise capital or to raise the company’s public profile, sometimes both.

The biggest reason for most companies to go public is raising capital, especially if other options (like venture capital firms or bank loans) are too expensive. The second reason is publicity—going public generates a lot of press for a business, and some companies want the standing that comes from being a public company. It often makes good financial sense, since it may allow the business to secure better lending terms in the future.

Why Participate in an IPO?

As an investor, there are several reasons you might participate in an IPO. The biggest is being able to purchase shares in a highly successful company and benefiting from that company’s strong performance, especially if you could not previously afford to invest in the company as a private investor.

That said, IPOs are considered a risky investment. For one thing, you don’t know how the company will perform in the future, just like any other investment. But going public also introduces new ongoing expenses for a company, often expenses that have nothing to do with the business itself. Plus, introducing new shares affects the overall share price, which can be a major distraction for management if that management is compensated based on share price.

Smart Investments to Build Your Financial Success

An initial public offering can be an exciting opportunity for the right investor. But before you get that far, you have to be prepared to do your homework.

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