Initial Public Offer (IPO): Definition, How They Work and Their Purpose

An IPO, or Initial Public Offering, is a company's first introduction to the public market. They can be quiet affairs or major events depending on the company's profile.

No matter how many headlines they generate, IPOs are an essential part of corporate funding. Here's what they are and how they work.

What Is an Initial Public Offering (IPO)?

An IPO is the process by which a private company issues its first shares of stock for public sale. This is also known as "going public."

Companies do not begin an IPO upon launch. While successful startups may go public eventually, it takes a firm time to establish the necessary business plan and market position. This is, in part, so that the firm can attract investors and in part so that it can meet many of the SEC's qualifications for an IPO.

Prior to launching an IPO a company may be held entirely by its founders or by a combination of firm principals and private shareholders. At this point the firm entirely controls its ownership structure. If it has shares, the firm's principals can restrict those shares to purchasers or investors of their choosing.

Upon launching an IPO the firm takes a portion of its ownership shares and makes them publicly accessible. Those stocks become the subject of market bidding and the firm cannot control who buys them. (This is the origin of the concept of a "hostile takeover." When a firm has placed more than 50% of its ownership on the public market it is possible for a competitor to purchase those shares even against the firm's wishes.)

An IPO is the process by which a firm places shares on the public market for the first time.

The Purpose of an IPO

The two main reasons for a firm to launch an IPO is to raise capital and to enrich prior investors. These are not unrelated.

By going public, a firm gets access to the entire world of possible investment. This can give it access to substantially more capital than most firms can get through private shareholders or venture capitalists. Typically a firm will launch in IPO when it reaches a plateau in what it can achieve through private capital and will use those funds to expand or continue growing.

In addition, the potential of a future IPO is one major incentive that fledgling firms use to attract initial investors. By selling their holdings, existing shareholders in the firm can recoup value from a successful public offering. The potential for this windfall allows young firms to attract the capital they need to operate while still small and privately held, and it rewards principals and early employees for taking a risk on an unproven firm.

How an IPO Works

An initial public offering is the process of structuring a firm's shares for sale, establishing stakeholders, and establishing regulatory compliance chiefly centered around financial disclosures and transparency. Most of this process exists to protect the general public from purchasing shares in fraudulent companies.

While the full process of an IPO involves a significant amount of both legal and accounting detail, here is the general framework:

  1. The firm hires an underwriter, almost always an investment bank, to advise and fund the IPO. This bank will typically approach institutions and investors to create initial interest in the IPO in what is called the "road show" and will help with the disclosures and regulatory process.
  2. The underwriter may also guarantee the initial public offering by purchasing the company's entire offering at an agreed-upon price, then selling that stock publicly itself. This is called a firm commitment. The alternative is a best efforts agreement, in which the underwriter sells the initial shares but does not provide any financial guarantees.
  3. The company hires a third party accounting firm to conduct a complete audit of its finances.
  4. The company, aided by its underwriter, assembles SEC registration documents. These include a prospectus, which is circulated to all potential investors, and private filings, which are for the SEC's eyes only. The registration documents include detailed financial information (including the third party audits), information on the company's management, its potential liabilities, private share ownership and its business plan.
  5. The SEC conducts due diligence to ensure that all information in the registration documents was accurate and complete.
  6. After the SEC approves the filing the prospectus is circulated to potential investors and a date for the IPO is set. If the company and the underwriter have not yet agreed upon an initial price or quantity of shares, they do so now.

Once these steps have been met, the stock is issued for public sale.

Profit from the sale of shares depends on the agreement between the company and its underwriter. If they made a firm commitment, then all of the money for each share sold in an IPO goes to the underwriting bank. If not, the company and its shareholders get the money directly.

During this process the company will also decide how much control it will put up for sale. Contrary to popular belief, a company does not have to post 100% of its equity during the initial public offering. It can sell as little or as much control of the firm as it chooses.

Finally, once a company has gone public it gains ongoing disclosure requirements regarding its finances, taxes, liabilities, business operations and more. This is often seen as one of the chief downsides to an IPO along with handing over control of a portion of the company. It is also the consequence of an initial public offering; once a firm is in ongoing compliance with public disclosure requirements, a subsidiary offering is far less significant.

IPOs and Investors

An IPO tends to be a  relatively risky investment for retail investors.

On the one hand, the right offering can be extremely profitable. A strong IPO can lead to very high gains and can allow investors early entry into a hot stock.

However, they also have a tendency towards volatility. Many IPOs are intentionally undervalued by the issuing firms so that they can get the positive headlines that come with strong initial trading, but this also can lead those stocks to high-value/low-value swings until they find a stable price. Further, early trading for an IPO can often be driven as much by enthusiasm as business fundamentals.

As the market saw in such high profile cases as Facebook (FB) and Snapchat, (SNAP) it is not uncommon for a company to launch a high-value IPO that then dips significantly. This often may have less to do with the business than with emotional investing.

For many retail investors, a late-stage IPO may often prove the better investment. By waiting for several months you can let the volatility work itself out of the market, and you will not be competing with large firms for the initial tranche of shares. While you may miss out on the occasional explosive-value offering, it is likely the far safer play in the long run.

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