What is an IPO (Initial Public Offering)?

DEFINITION

Through an IPO, a private company becomes a public one by offering its stock for the first time on a public stock exchange to investors.


🤔 Understanding an IPO


An Initial Public Offering (IPO) is how a company can transform from being privately owned by a select group of investors to publicly available so the general public can invest. It’s a lengthy process in which investment banks usually help the IPO’ing company determine an appropriate price to sell its shares on the stock market — and it culminates with List Day, when the shares become tradable. With all of the possible pent-up anticipation for the newly and publicly available shares, the IPO can be an intense moment for the company and investors, so it’s important to understand certain risks that come with IPO enthusiasm.


EXAMPLE

After growing since 2012 as a privately-held company owned by the founders, employees, and early investors, Lyft’s shares are now available to the public because it IPO’d in March 2019 on the Nasdaq stock exchange. Other major 2019 IPOs include Uber, Beyond Meat, Zoom, Pinterest, and more.



Takeaway

With great excitement comes great responsibility...

When a company IPOs, its stock becomes listed on the public investing menu for the first time. It can be tempting to purchase stock in recent IPO companies because there’s often media hype surrounding the event (think of your friends discussing the Facebook or Uber IPOs. A lot.). But IPO investing can be like jumping into the deep-end — it may not be appropriate as an investment for beginning investors looking for stable or predictable investments because the stock price can get volatile.


IPO Overview


An Initial Public Offering (IPO) is a company’s first time offering its stock for sale to the public, and it generally coincides with listing its shares on a public stock exchange. An IPO is one way a company can “go public” (transition from being owned by private investors only to being available to the general public). The other way is a Direct Listing (more on that below). For everyday non-institutional investors like you, an IPO is when a company becomes investable. Before the IPO, only a select group of investors typically have the opportunity to invest. After the IPO, the general public can buy or sell shares of a company through a brokerage firm


Why do companies list their stocks?


Funding the business: Startups need cash to operate and grow. Typically, entrepreneurs rely on the money in their pockets to launch their idea. Then they ask family and friends to invest, followed by angel investors and venture capitalists. Eventually, many companies want the benefits of publicly traded shares, which happens through an IPO. It’s an opportunity to raise new money to grow the business by issuing new stock in exchange for cash.


Cashing out: Another benefit is liquidity for early shareholders of the company — that includes the founders, early employees, and initial investors. It’s harder for them to turn their company shares into cash while the company is private. But public companies have shares that can be sold on the stock markets open to the general public.


Mature the company: Finally, being publicly owned is a whole new set of responsibilities. You’ll notice that you can probably find more detailed info online of public companies than private ones. That’s because public companies have to comply with stringent financial reporting requirements for their shareholders (like quarterly earnings reports). Since public companies have to publicly share so much information, it can encourage them to pursue stronger management and communication practices to benefit their shareholders.


Pricing and listing stock in an IPO


It’s not easy for a company to decide what shares are worth. The IPO process usually begins with the company hiring one or more investment banks to help it decide the initial price of its shares. Then the company issues a prospectus registration statement (or S-1) detailing its business model and plans for the funds raised. After that, the company and its banks can hit a roadshow to discuss its business model with institutional investors, who give an indication of interest in buying the stock — this helps the company and its bankers determine the share price. With the initial stock price determined, the company creates new stock to offer to the public on stock markets in an IPO. In exchange for its shares, the company receives money paid by investors. After the IPO, its stock is freely tradable, and most investors (except certain company insiders with restrictions) can buy or sell shares as they please.

For example, some past IPOs include Facebook in 2012, Blue Apron in 2016, and Lyft in 2019. You can learn more about the risks and potential rewards of investing in recently listed stocks in the risk section below.


Direct Listing: An alternative way to go public


Both IPOs and Direct Listings give individual investors access to invest in companies for the first time, but there are some key differences.

With a Direct Listing, the company offers its stock publicly on a stock exchange for individual investors to buy. At the same time, a Direct Listing lets the company’s existing private investors “cash out,” by selling their (once-private) shares to retail investors in the (now public) markets. A Direct Listing skips the investor roadshow that’s featured in an IPO because the company is not issuing any new shares and isn’t raising any new capital. That means fewer fees paid to investment banks that guide the IPO process, so Direct Listings therefore can have lower costs to the stock-issuing companies.

Spotify’s 2018 Direct Listing is our go-to example. Companies with strong brands that aren’t looking to raise new capital are generally attracted to Direct Listings. They don’t need a roadshow to build interest in their stock (because they’re well known and aren’t issuing new shares), so they don’t have to pay as many fees to investment banks (who typically guide the IPO process). Their core need is typically the ability to list their shares public so early investors and shareholders can sell off their stakes — the Direct Listing can satisfy that, possibly more efficiently.


Are IPOs “good” investments?


IPOs can be tempting — suddenly a brand you use daily may be available to invest in for the first time. But investing in a company’s stock during or soon after an IPO may not be appropriate for beginner investors looking for stable or predictable investments. Like any investment in stock, the value of the stock can rise or fall after an IPO. But spikes in either direction tend to be more dramatic in the early stages of trading of a stock. One reason is that investors are still deciding how much the stock should be worth. Another is increased media attention can generate hype — good or bad — for recently listed companies.


Are there risks to trading a recently listed stock?


Yes. There are risks to trading all stocks, especially stocks of companies that recently listed — stock price volatility tends to be higher, so the share price can rise or fall by significant amounts on a single day. Sometimes, there’s pent-up interest and media attention in the ability to buy a company’s shares for the first time. Even statements by the company’s leadership or bank underwriters can influence how investors feel, and they may be overly optimistic or pessimistic in the early days of trading.


IPOs can generate hype: Investors shouldn’t get carried away by IPO excitement, and avoid letting emotions (even good old fashioned peer pressure) influence their investment decisions. This heightened attention and media scrutiny can contribute to volatility, so investors should be prepared.


Price support by investment banks: In the first days following an IPO, the bank underwriters are allowed to protect the stock price from falling too much. They may even buy shares of the newly-listed company. Once this support ends, the stock price has the potential to fall below the offering price. Investors should be aware of price supporting (it’s publicly mentioned in the company’s IPO registration paperwork).