What is an IPO? How it works

An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time, allowing it to be traded on a stock exchange. By going public, the company can raise capital from a broader pool of investors, which it can use to fund growth, pay off debt, or for other corporate purposes.

Here's a breakdown of key aspects of an IPO:

• Going public: Before an IPO, a company is privately held, often by its founders, employees, and private investors. The IPO marks the transition to becoming a public company, where anyone can buy and sell shares on the stock market.
• Raising capital: The primary reason companies go public is to raise capital. By selling shares to the public, the company can generate significant funds to invest in new projects, expand operations, or pay down existing liabilities.
• Underwriters: Investment banks typically act as underwriters during an IPO. They help determine the offering price, buy the shares from the company, and then sell them to the public. The underwriters also help navigate the regulatory process and ensure the IPO is a success.
• Pricing: The offering price of shares is determined based on factors like the company's financial health, market conditions, and investor demand. The price can fluctuate after the IPO as the stock begins to trade on the open market.
• Regulatory requirements: Companies undergoing an IPO must comply with regulatory requirements, such as filing a registration statement with the relevant securities commission (e.g., the SEC in the United States). This document, called a prospectus, provides detailed information about the company’s business, finances, and risks to potential investors.
• Post-IPO: After the IPO, the company’s shares are traded on the stock exchange, and it must meet ongoing regulatory requirements, including regular financial disclosures and governance standards.

IPOs are often seen as a milestone in a company's growth, offering a way for early investors and employees to realize gains on their equity while providing the company with new capital to fuel its ambitions. However, going public also subjects the company to greater scrutiny and the pressures of meeting shareholders' expectations.

Understanding the IPO process

Going public is a complex and time-consuming endeavor that most companies find challenging to navigate on their own. A private company aiming for an Initial Public Offering (IPO) must not only prepare for increased public scrutiny but also complete extensive paperwork and financial disclosures to meet the regulatory requirements set by the Securities and Exchange Commission (SEC), which governs public companies.

To manage this intricate process, a company typically hires an underwriter, usually an investment bank, to guide the IPO and assist in setting the initial offering price. The underwriter works closely with the company's management to prepare for the IPO by creating essential documents for potential investors and organizing roadshows—meetings where company executives present their case to potential investors.

According to Robert R. Johnson, Ph.D., a chartered financial analyst (CFA) and finance professor at the Heider College of Business at Creighton University, "The underwriter forms a syndicate of investment banking firms to ensure broad distribution of the new IPO shares. Each firm in the syndicate is responsible for distributing a portion of the shares."

After the initial offering price is set, the underwriter issues shares to investors, and the company's stock begins trading on a public exchange, such as the New York Stock Exchange (NYSE) or the Nasdaq.

Reasons for a company to pursue an IPO

An Initial Public Offering (IPO) often represents the first opportunity for the general public to purchase shares in a company. However, one of the main objectives of an IPO is to allow early investors to liquidate their investments.

An IPO signifies the transition from one phase in a company’s journey to another. For many startups and emerging ventures, it offers an exit strategy for original investors looking to cash out. Similarly, investors in more established private companies going public might also seek to sell some or all of their shares.

Matt Chancey, a certified financial planner (CFP) from Tampa, Florida, points out, “Initially, there’s often a friends and family round, followed by investments from angel investors. A lot of private funding—similar to what you see on shows like Shark Tank—supports a company before it goes public.”

How to invest in IPOs

Purchasing shares in an Initial Public Offering (IPO) is not as straightforward as placing a typical stock order. To participate in an IPO, you need to work with a brokerage that facilitates IPO investments, as not all brokers offer this service.

Gregory Sichenzia, founding partner of Sichenzia Ross Ference, a securities law firm based in New York City, explains, “Typically, you would need to buy IPO shares through your stock broker. Occasionally, you might be able to buy directly from the underwriter, which could involve having connections with the company or investment bank.”

Major brokers such as TD Ameritrade, Fidelity, Charles Schwab, and E*TRADE might provide access to IPOs. However, they often impose specific eligibility criteria, such as maintaining a minimum account balance or meeting a trading activity threshold.

One of the biggest challenges for retail investors is securing shares at the initial offering price. Since IPO shares are in high demand, they often sell out quickly. By the time retail investors can buy the shares, the price may have surged significantly. For example, you might end up buying shares for $50 each even though the IPO price was $25, missing out on early gains.

To address this issue, platforms like Robinhood and SoFi now offer opportunities for retail investors to purchase IPO shares at the initial offering price. Despite this, it is crucial to conduct thorough research before investing in any IPO. Assess the company’s financial health, market potential, and overall investment strategy to make an informed decision.

Should you consider investing in IPOs?

Investing in an Initial Public Offering (IPO) comes with its own set of risks, often greater than those associated with established public companies. This is primarily because private companies lack the extensive data and historical performance metrics available for public firms, leading to higher uncertainty for investors.

While there are stories of significant profits from IPOs, the reality is that many IPOs do not perform well. For instance, over 60% of IPOs between 1975 and 2011 experienced negative returns after five years.

Consider the case of Lyft, which went public in March 2019 at $78.29 per share. The stock price dropped sharply, falling to around $21 within a year. Although it has since risen to above $57, early investors who bought at the IPO price would still be at a loss.

Similarly, Peloton’s IPO in September 2019 was initially priced at $29 per share but started trading at $25.24. It struggled in the beginning, hitting a low of $19.72 in March 2020. Despite its eventual rise to $154.67 by February 2021, the journey was tumultuous, raising the question of whether investors could endure the stock's lows to benefit from its peak.

As Matt Chancey points out, "Just because a company goes public doesn’t necessarily make it a good long-term investment." Pets.com is a notorious example; it went public at around $11 per share, but its price plummeted to $0.19 within 10 months due to overvaluation, high operating costs, and the Dot Com bubble burst.

Even if a company has strong potential, its IPO price might not reflect its true value. Chancey notes, "You could buy the best business in the world, but if you overpay by 10 times, it’s going to be difficult to recover your investment."

In the view of financial expert Gagliardi, buying IPOs often leans more towards speculation rather than investing. Many shares are quickly sold on the first day of trading, creating volatility. For those interested in a stock, waiting a few weeks or months for the initial excitement to settle and prices to adjust might be a more prudent strategy.

SPACs vs. IPOs: Understanding the differences

In recent years, Special Purpose Acquisition Companies (SPACs) have gained popularity as an alternative route to going public, offering a different approach compared to traditional Initial Public Offerings (IPOs). Often referred to as “blank check companies,” SPACs are created specifically to raise capital through an IPO with the sole purpose of acquiring an existing company.

Well-known Wall Street investors frequently use their reputations to establish SPACs, attract investment, and pursue acquisitions. However, investors in SPACs may not always know which companies the SPAC intends to target. Some SPACs provide general indications about the types of companies they plan to acquire, while others offer no such information, leaving investors uncertain about potential deals.

As George Gagliardi, a Certified Financial Planner (CFP) from Lexington, Massachusetts, puts it, “Investing in a SPAC is like giving your money to an entity that doesn’t own anything yet and saying, ‘Trust me, I’ll make good acquisitions with it.’ It’s akin to a baseball batter wearing a blindfold—you’re unsure of what’s coming.”

For private companies, SPACs offer a faster route to going public compared to the traditional IPO process. Since SPACs are newly formed entities, they do not have extensive financial histories to disclose to the Securities and Exchange Commission (SEC). Additionally, investors in SPACs typically have a safety net: if the SPAC fails to complete an acquisition within 24 months, investors can generally recoup their money.

While SPACs can provide a streamlined path to public markets and offer some protections for investors, they also come with their own set of risks and uncertainties. Unlike IPOs, where companies offer detailed financial disclosures and business plans, SPAC investors may be investing without knowing the specifics of future acquisitions, which can add an element of speculation to the investment.