IPO (Initial Public Offering) – A Comprehensive Guide

Infographic explaining what an IPO is, the key characteristics of companies that IPO, and reasons why a company IPOs.

IPO, short for Initial Public Offering, has been a topic of discussion for decades now. When people hear about an upcoming IPO, they often think the following: “Some people are going to get very rich after the IPO,” “Wish I would have paid better attention earlier and gotten involved in this company before the IPO,” and “When would be a good time for me to buy shares in this company.” This all sounds very exciting, which it is. However, it does not really show how much work goes into this, how difficult the IPO process is and how expensive it is for a company to go public. 

Many private and startup companies’ ultimate goal is to get acquired by another company or go public and get listed on a major stock exchange. As we all know, very few companies reach either one of those goals. Still, for the ones that do, it often depends on the founder’s vision. Does the founder want to sell the company and use the money for a new “project” or get rich and get the acknowledgment and influence that goes with being listed on the stock market? 

When a company decides to go public, we often hear about in the news, and we see on tv how company executives ring the bell on opening day at the stock exchange where the company’s stock is listed. For days, investors on Wall Street will be talking about it. No matter how much “hype” there is about new IPOs, and their success or failure, it is clear that IPOs are essential to some companies to get the bulk of their funding.

This article will review what exactly an Initial Public Offering is, why companies undertake one, what the pros and cons are, and what the process entails. Finally, we will conclude with a section on who can invest in Initial Public Offerings and how.

What Is an IPO?

An Initial Public Offering, also called a stock market launch, is how a previously privately held company issues shares of stock to the public for the first time. Private companies usually go public to raise enough capital to invest in future operations and expansions. The IPO is offered to institutional investors only, as the IPO company is looking for a lot of capital that only large investment banks can offer. After the IPO date, the shares will be available to the general public on the open market.

Deciding to list shares on the public market is a difficult decision for a private company. It means a loss of control and a lot of extra work and expenses. However, for many companies that have reached a certain stage, it is the only way to attract enough capital to keep growing and staying successful.

Not every company wants to go public, but for the ones that do, timing is everything. A healthy economy and stock market usually are helpful to make an IPO successful, as investor confidence is high at that time.

Characteristics of Companies That Are Ready to IPO

Good timing is not the only requirement for a company to have a successful IPO. Here are some must-have traits that will make a company a successful IPO candidate. 

  1. Ability to accurately forecast financial performance. Missed earnings or budgets will reduce the company’s valuation and negatively impact the ability to attract institutional investors. The company also needs to show that it has business processes in place that make the company run smoothly and that it can comply with all the financial reporting requirements it will have once it is a public company. 
  2.  Quality of management. The company needs to make sure that the management team can handle the increase in responsibility that comes with being a public company. The areas of accounting, investor relations, and regulatory will need to be run by experienced executive management team members.
  3. The industry or sector the company is in has to show a lot of growth potential. Without considerable future growth, investors will not be interested in being part of the IPO.
  4. A comprehensive strategic business plan is a must. Investors want to see the company’s plan for the next few years and how it will get there. This will be an indication of the expected return on investment. Investors also want to see that an IPO is the best way to accomplish this plan.
  5.  A low debt-to-equity ratio. A company with high debt will definitely scare investors away and negatively impact the initial share price. 

History of U.S. Initial Public Offerings

History has shown that the number of Initial Public Offerings can fluctuate throughout the years. Innovation and various economic factors are usually the cause of these fluctuations. During a recession, the number drops as the low stock prices do not warrant the expense of an IPO. The number of new IPOs reached an all-time high of almost 500 in1999 as the DOT COM bubble was growing, and tech companies without revenue even issued IPOs. Then, in 2001 when that bubble burst, the number of new IPOs declined significantly and stayed low for several years.

Between 2004 and 2007, the number slowly started rising again, but then, the 2008 financial crisis hit, and the number of new initial public offerings dropped to an all-time low. Then, for the next decade, the number fluctuated between levels of 100 and 300 per year.

Recently, the IPO market has significantly improved, and 2020 turned out to be a stellar IPO year, although it did not quite reach the 1999 level. The number was well over 400, which was more than double the number of IPOs In 2019, and the forecast for 2021 is even higher. Airbnb and DoorDash were a couple of the biggest companies that went public in 2020. They raised about $3.5 Billion and $3.4 Billion, respectively.

Although IPOs are coming back, most companies do not want to go public with an IPO because investors and founders of these private companies believe that Initial Public Offerings are way too expensive. In addition, the required disclosures may reveal the company’s secrets to success. Another reason is that many of the IPO candidates are tech companies and need less capital. On top of that, Venture Capitalists have become larger and larger and can fund private companies longer. 

Some companies consider alternative strategies to an IPO, such as a Direct Listing, also called a Direct Public Offering (DPO). DPOs do not issue new shares. They only offer existing, outstanding shares to the public. As a result, no underwriters are needed for a Direct Listing. Although this is a riskier strategy, it can result in a higher share price. This strategy only works for companies with an established name. In 2018, Spotify used Direct Listing as a way to go public.

In the last few years, many companies that issued IPOs were private startups with more than $1 billion in valuations. These companies are called unicorns, and their number is rising. These unicorns are the topic of continuous discussions and speculations amongst investors. Which ones will go public, and which ones will stay private?

Why Does a Company Issue an IPO?

The number of investors in private startups is usually small. These startups get their money from the owner’s or founder’s personal funds. Sometimes get supplemental business loans or money from angel investors or venture capitalists. However, at some point, the company will reach a stage where future growth will only be possible with a major capital expansion. By issuing an IPO, the company will have access to substantial capital by offering shares to the public. It is the potential future growth that serves as an incentive for investors.

Another reason a private company might want to go public is to enrich its investors. Sometimes IPOs are seen as an exit strategy for early investors or founders who do not really want to be involved in a large company. They want to sell and move on. Other investors might want the acknowledgment and fame that comes with going public, or maybe they just want to get rich.

How Do IPOs Work and What Is the IPO Process?

Initial Public Offerings are fascinating, but the actual process is a very lengthy one. Before the process can start, the company has to make sure that they are ready for the challenges that going public brings with it. A strong management team is the key to success. 

Once the team is in place, the formal IPO process can start. The process is very time-consuming and can take anywhere from a few months to a couple of years. Here are the usual steps in the Initial Public Offering process:

An infographic that shows the 7 steps of the IPO process.
  1. Hire an underwriter. This is one of the most important steps in the process, as the underwriter will lead the company through the whole process and fund the IPO. Sometimes a company decides to hire several underwriters who will work as a team. The underwriter will be an investment bank that specializes in IPOs. Applicant banks submit bids with details on how much the IPO will raise and what the bank’s fees are. Then the company selects the bank based on its reputation and expertise. An underwriting agreement that details the terms, the amount of money to be raised, the type of securities to be issued, and all the associated fees gets signed between the company and the underwriter.
  2. Due Diligence. This step takes the longest. It involves the assembly of all the financial information required and the submission of the regulatory filing. The company must file the S1 registration statement with the Securities and Exchange Commission (SEC). The S1 has 2 parts. The first part is the information required in the prospectus. This is the document that the issuing company has to provide to everyone who gets to buy the stock. The second part is the information that does not have to be in the prospectus but that the SEC needs. This includes everything from financial statements, legal matters, who owns stock, and executive information. The SEC will thoroughly investigate the company to make sure all the information is correct. Another part of due diligence is the contract between the company and the underwriter.
  3. Roadshow. The underwriter and the issuing company will travel to different places to promote their share issuance to investors. Thye do this to find out what the demand for the shares is and estimate how many shares to offer.
  4. Price. After the SEC approves the offering, the company and the underwriter agree on the issuance date, the number of shares available for issue, and the initial offering price. The agreed-upon share price is based on the company’s value, the amount of money to be raised, the success of the roadshow, and the state of the economy. IPOs are often ntentionally underpriced to reduce the risk and increase the demand. This will increase short-term trading after the shares are available to the public, which, in turn, will result in a price increase. During this price-setting stage, the company must also join the stock exchange that will list its stock and comply with all the rules and regulations set by that exchange. Before the effective date, the underwriter will notify the bidding investors how many shares they get to buy.
  5. The underwriter will issue its initial shares on the IPO date. The company has gone public.
  6. Stabilization. Immediately after the Initial Public Offering, there is a 25-day quiet period that is a window of opportunity for the underwriter to create a market for the stock and keep its price at a reasonable level by making sure there are enough buyers. There is also a lock-up period, which is a preset amount of time (usually between 90 and 180 days), during which people who own shares before the offering cannot sell their stocks.
  7. Transition to market competition. After the quiet period has ended, the stock is part of the normal market, and the underwriter cannot intervene anymore. Underwriters can estimate the company’s earnings, but investors will have to start relying on market data.

Most companies are not aware that an IPO does not require a company to include 100% of its shares in the offering.

Pros and Cons of an IPO

When a company reaches the point that it is going public, it is an indication that it has become successful enough to attract more capital and grow extensively. Besides the capital it provides, Initial Public Offerings have some other benefits as well. On the flip side, going public also has some disadvantages. Those disadvantages might actually keep a company from issuing an IPO. Instead, some companies might try to get their capital through other strategies such as Direct Listings or Reverse Mergers. Here are some of the advantages and disadvantages of an Initial Public Offering. 

Pros:

  • It offers the company access to a lot of capital from public investors in the primary market and later in the secondary market.
  • It can make acquisitions easier, because the shares are now publicly available which makes valuing the company easier.
  • Going public allows companies to attract the industry’s top talent as the company can use incentives such as stock options. 
  • IPO shares have the potential to skyrocket in value within a small period of time. 
  • The increased financial health and transparency of the company often result in a lower cost of capital.
  • Going public will offer the original owners and investors an exit strategy and the opportunity to make a lot of money.
  • An IPO increases a company’s exposure, prestige, and public image.

Cons:

  • Going public is a costly process. Besides the extra costs involved, financial and legal reporting will be ongoing.
  • Managing the Initial Public Offering is very time-consuming and requires a lot of effort and attention while there is always a risk that the required funds won’t get raised. Even after going public, a lot of extra time wiill be necessary on an ongoing basis to prepare all the financial and legal reports that public companies must to publish.
  • Competitors, suppliers, and customers can use public dissemination of company information.
  • Possible loss of control for the original owners. The Board of Directors takes charge and can now effectively control a company’s decisions.
  • Going public increases the risk of litigations, such as class action lawsuits.

How to Buy IPO Stocks?

An Initial Public Offering is offered to institutional investors and not to individual investors. Reason being that the issuing company is looking for large amounts of capital that usually only large investment banks can offer. Buying an IPO stock is a matter of opportunity. Sometimes, underwriter institutions present the opportunity to buy shares before the first day of trading to a few of their regular customers.

Initial Public Offerings are usually volatile and unpredictable. However, the actual buying process is quite simple and is the same as buying any other stock. As long as you have a brokerage account, you can purchase the stocks on the exchange when the company goes public. 

The advantage of investing in an IPO is that investors might be able to buy an underpriced stock early on before the price goes up and potentially benefit from price jumps on listing day and later on. To get in early and capitalize on available opportunities, investors need to find out about upcoming IPOs early on. They can find information on upcoming IPOs on websites from exchanges like the New York Stock Exchange (NYSE) and the NASDAQ or websites like Google News and IPO Monitor. These websites publish IPO calendars that list upcoming and future expected offerings. They include the company name and ticker, IPO date, IPO price range, and the number of new shares of stock offered,

Factors to Consider Before Investing in an IPO?

For retail investors, Initial Public Offerings are pretty risky investments. However, they can be very profitable in early-stage investing. They can offer high gains after the company has gone public. This is especially true since the issuing company intentionally undervalues many offerings to increase the shares’ sales. However, this can also create a lot of volatility in the share price. Eventually, the price will stabilize in a later stage. In the early stages, the share price is more the result of investor sentiment than actual business fundamentals. So, buyer be aware.

When considering investing in IPO stocks, please note that not all IPOs are successful. Even some of the biggest ones, such as Facebook, can be failures. Facebook’s launched on May 18, 2012, at $38. Then the stock fell and reached its bottom on September 4, 2012, at $17.73.  In 2013, Facebook shares started to rise again and have since far surpassed their issue price. In the short term, Facebook would have been a bad investment. However, in the long run, it has been a great investment.

So, it is clear that investing in an IPO can certainly be rewarding. However, we cannot ignore the risks involved. So, here are some things that a retail investor should consider before investing in IPO stocks.

Research the company and its investment objective

In-depth research of the company is a must. Study the prospectus, follow the headlines, and make sure all the company financials are sound. Also, find out why the company needs investment and understand the company’s growth trajectory. 

Look at Valuation Statistics

For retail investors, this is an important aspect that should never be overlooked. The valuation will show how the company fares in comparison to other companies in the industry. Looking at ratios such as the Price-to-Earnings ratio can be helpful in the valuation of the stocks.

Know when the lock-up periods and waiting periods end

When a company goes public, company insiders must sign an agreement prohibiting them from selling any shares for a specified period of time. This can be anywhere from 3 to 24 months. This is called a lock-up period. The problem arises when this period ends, and all the insiders can sell their stocks. This can result in a significant drop in the share price. Another waiting period is assigned to stock that is allocated to be issued after a specific date. This might increase or decrease the share price as well.

Be aware of flippers when a stock is undervalued​

When a stock is undervalued at offering, it is pretty common for some investors to try to make a quick profit by reselling this IPO stock in the first few days for a higher price.

Conclusion:

Investing in an Initial Public Offering, or IPO, sounds very exciting and can be very beneficial. Still, before any stock investment, you need to understand the fundamentals of the company’s operations. Unfortunately, with an IPO, that is a little harder to do because there is a lot of uncertainty around the stock price valuation, its future growth, and the expected volatility during the first few minutes of trading.

If you are a short-term investor, investing in IPO stocks might be too risky. If you are a long-term investor and have done your research and like the company’s fundamentals, investing in IPO stock might be a good strategy. However, there are fewer IPO investment opportunities available because many companies are choosing to stay private longer. Some companies want to get acquired by other companies, and some can stay private longer because of the availability of capital through Venture Capitalists and Angel Investors.

Investing in an IPO can be very lucrative but also comes with a high risk. If you do decide to take the plunge, make sure to do the research and be patient.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.