How Does an IPO Work?

W hen a private company wants to begin selling shares of its stock to the public, it makes an initial public offering (IPO). While the primary purpose of an IPO is to raise significant capital from the investing public, this step also raises the profile of the firm and creates further opportunities for expansion and growth. Explore how this process works behind the scenes.

What Is an IPO?

How does an IPO work? An initial public offering allows the public to purchase shares in a company’s profits to raise capital for growth, expansion, and other endeavors. As the company grows, shareholders benefit from the increase in the value of their stock and other advantages, such as voting rights, while its early private investors can take advantage of benefits like premiums and preferred shares.

A firm issuing an IPO must meet all regulations of the federal Securities and Exchange Commission. This ensures that the company provides transparency to the public.

Before issuing an IPO, a company’s investors are limited to its founders and their personal networks, angel investors, and venture capitalists. After an IPO, the firm can access public capital as well as favorable terms when borrowing funds to expand the business.

To understand how an IPO works, review the steps to forming an IPO. These include:

  1. Starting the IPO process: This occurs when a firm hits a value of at least $1 billion or displays significant growth potential and the founders determine that an IPO is the best way to expand.
  2. Finding an underwriter: An investment firm or bank will facilitate the IPO process, purchasing the initial release and reselling to institutional investors and other stakeholders.
  3. Creating IPO documentation: These documents must be reviewed and approved by the Securities and Exchange Commission before the IPO moves forward.
  4. Pricing and marketing the IPO: The right share price will drive both profit and demand, informed by the process of advertising the new release. The underwriting team does not finalize the price until the day before the IPO.
  5. Releasing the IPO: The majority of shares go to brokerage firms and other institutional investors.

Starting the IPO Process

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First, when the company’s founders make a decision to go public, they must initiate the IPO process. Usually this happens when the firm has a value of $1 billion or higher, but companies with a lower value can be IPO-eligible as long as they can meet SEC requirements and display strong potential for growth and profit.

Sometimes, the firm will make a public statement about its upcoming IPO. They may also conduct a private search for an underwriting institution to value its shares and issue the IPO.

Before releasing an IPO, a company is completely owned by its founders and original investors, which may include venture capitalists, angel investors, or private shareholders. After the release, the shareholders own the company and hold sway over its direction with voting rights. However, a company does not have to sell its entire equity in the form of stocks. Often, they will decide to offer only a percentage of shares to the public and keep the remaining shares under private ownership.

Finding an Underwriter

The company offering an IPO must hire a professional valuation firm to conduct due diligence in pricing its IPO shares. Each underwriting company offers a proposal that details its services and makes recommendations about the types of shares the firm should issue, the number of shares, the offering price, and the proposed schedule for the IPO.

When the company selects an underwriter, they will enter a formal agreement that details the complete terms of the IPO. They also assemble the underwriting team, which consists of the underwriters and the executives from the company as well as SEC experts, accountants, and attorneys.

Creating IPO Documentation

The official SEC paperwork to apply for an IPO includes the S-1 registration statement. This document includes the company’s private filing information and IPO prospectus. As the committee gets closer to the IPO date, they will frequently revise this document to reflect the final offering.

The S-1 includes the company’s business plan, details about the ownership of its private shares, possible liabilities such as legal issues, biographies of each founder and member of the executive team, and comprehensive financial information including the results of an independent audit.

The SEC will review the IPO application and ensure that the company meets federal regulations. After approving the IPO, the SEC requires the company to regularly provide public disclosure of its financial standing, hold shareholder meetings, and follow other federal guidelines.

Pricing the IPO

The committee will also develop marketing materials to advertise the upcoming IPO. The marketing process will inform the final IPO offering price, as it allows the committee to gauge demand for the new public shares.

During this step, the company must consider the transition for its private shareholders. Often, their holdings will convert to public shares at the new, higher value. However, many private investors decide to cash in their shares and realize their returns when the company goes public.

As the company prepares to go public, the underwriting firm presents the prospectus to potential investors from all over the world. While these can be in-person presentations, as suggested by the common moniker ‘roadshow,’ many such events actually occur virtually.

When an investor is impressed by the IPO presentation, they can obtain an allocation of shares at the IPO price before the stock goes public. Usually, this process targets large institutional investors. Ideally, the roadshow will build buzz for the release of the new shares. The amount of interest generated during the run-up to the IPO will also inform the eventual share price.

Releasing the IPO

The underwriter and the company will work together to set a final stock price the day before the IPO drops. This is often quite different from the target price the team set at the beginning of the process. The right stock price is critical; ideally, it will be high enough to drive demand and create a steady value increase, but not so high that demand will flag, which can cause the price to drop.

If you’re interested in an IPO as an individual investor, most experts recommend waiting a few weeks until the stock price settles. Institutional investors such as banks and brokers buy about 80% of the IPO shares, with the rest allocated to the firm and underwriter’s clients and associates.

Some brokers do offer IPO access to high-volume individual investors who do not have a history of flipping stocks (a practice that can artificially drive up the IPO price). If you think you may qualify, talk to your broker directly to learn more about the process. When purchasing an IPO, you should conduct the same due diligence as you would for other types of investments.

Advantages of Forming an IPO

Of course, the primary benefit of forming an IPO is the opportunity to access capital from the entire scope of public investors. Other advantages for the firm that decides to go public include:

  • Easier company valuation because of publicly listed share prices, which helps facilitate potential mergers and acquisitions.
  • Better terms for financing because of the transparent, publicly available information about the firm’s financial health.
  • Access to lower debt and equity costs.
  • Enhanced public image and publicity, which can increase the company’s sales and attract high-quality employees and managers.
  • The ability to offer stock equity as an employee benefit.
  • The ability to issue more stock shares to raise additional capital in the future without having to go through the SEC approval process for an IPO again.

Disadvantages of Forming an IPO

While issuing an IPO has many benefits, it’s not the right choice for every company. Some of the potential disadvantages of going public include:

  • The cost of issuing an IPO and managing a public company, which far exceed the costs of running a private company.
  • The requirement to publicly disclose the company’s complete financial information, which for some firms may result in the release of trade secrets to competitors.
  • The risk that the IPO will be unsuccessful.
  • The time and money required to fulfill quarterly SEC reporting requirements for public firms.
  • Potential regulatory and legal issues, such as shareholder lawsuits.
  • Potential loss of control to a new group of shareholders with voting rights and/or the new board of directors.
  • Changes in stock value can distract management from the firm’s core business objectives.

O nce the dust settles from the initial IPO release, the underwriting firm will issue a report about its performance. After six months (180 days), investors who owned shares in the company before the IPO can cash out and sell their percentages for a healthy profit. Understanding the question of how does an IPO work provides stock market insight that could help inform your trading activities.