What is an Initial Public Offering (IPO) and How Does it Work?

What is an initial public offering (IPO)?

In the financial markets, an initial public offering (IPO) describes the process by which a privately-held company offers its shares for sale to the general public for the first time. 

When a company “goes public,” it essentially transitions from being privately owned by a select group of investors (e.g. founders, venture capitalists, and private equity firms) to a publicly traded company with shares available for purchase on a stock exchange.

The offering process involves several key steps, including the selection of underwriters (investment banks that facilitate the IPO), the determination of the offering price, and the filing of regulatory documents with the Securities and Exchange Commission (SEC) to provide transparency and disclosures about the company's financial health and operations.

IPOs represent an opportunity to invest in a company at an early stage, and potentially participate in the appreciation of the company’s shares as it grows over time. However, there are significant risks with IPOs, as well. For example, not all young companies successfully develop into mature companies, which means some IPOs eventually decline in value. 

Another factor to keep in mind is that IPOs can be limited, and the majority of shares may be gobbled up by institutional investors and high-net-worth individuals that have priority access. As such, it's crucial to understand the IPO allocation process, and to determine whether a given IPO aligns with your overall investment strategy.

How do IPOs work?

An initial public offering is a complex and highly regulated process that involves a variety of steps, from the company's decision to go public, to its eventual listing on a stock exchange. This process typically requires extensive preparation, coordination with underwriters and regulatory authorities, and market analysis to ensure a successful debut in the market. 

The primary steps in the IPO process are highlighted in greater detail below.

Company Decision: The company's management, board of directors, and shareholders decide to pursue an IPO as a means of raising capital. 

Engagement of Underwriters: The company typically selects one or more investment banks or underwriters to facilitate the IPO process. These underwriters advise on valuation, regulatory compliance, marketing, and the distribution of shares to investors (among other things). 

Due Diligence and Documentation: The company conducts thorough due diligence to prepare financial statements, audit reports, and disclosure documents required by regulatory bodies, such as the Securities and Exchange Commission (SEC). 

Filing Registration Statement: The company files a registration statement with the relevant regulatory authority (e.g., Form S-1 in the U.S.) to provide detailed information about its financials, operations, management, and risk factors to potential investors.

Pre-Marketing and Roadshow: The underwriters engage in pre-marketing activities to gauge investor interest and set an indicative price range for the IPO. As part of this process, they often conduct roadshows, during which company executives present the business to institutional investors.

Pricing and Allocation: Using feedback from the roadshow, the underwriters determine the final offering price, and allocate shares to institutional investors and retail investors. This process aims to balance demand and supply.

SEC Review: The SEC reviews the registration statement for compliance with securities laws and other requirements. The company may need to address any concerns or questions raised during this review.

Trading Debut: On the scheduled IPO date, the company's shares are listed on a stock exchange, and public trading begins. However, the opening market price may differ from the final offering price.

Post-IPO Reporting and Compliance: The company must adhere to ongoing reporting and compliance requirements, including quarterly financial reports, annual reports, and disclosures of material events.

Lock-Up Period: Insiders and other early investors may be subject to lock-up agreements that restrict them from selling their shares for a specified period. This is done to help prevent excessive selling pressure during the period following the IPO. 

Market Performance: The stock's performance in the secondary market is closely monitored by investors, analysts, and the company. It may be influenced by the company’s financial results, market sentiment, and broader economic conditions.

Why do companies go public (IPO)?

Going public through an IPO is a significant decision for a company and its stakeholders. It involves selling shares to the public for the first time and listing them on a stock exchange.

Companies may choose to go public and conduct an Initial Public Offering (IPO) for various strategic reasons, as outlined below:  

  • Access to Capital: IPOs provide an opportunity to raise substantial capital by selling shares to a wide range of investors, which can be used for growth, expansion, debt reduction, or research and development.

  • Brand Visibility: IPOs can enhance a company's visibility and credibility in the marketplace, attracting customers, partners, and suppliers.

  • Attracting Talent: Publicly traded companies often find it easier to attract and retain top talent through stock-based compensation packages.

  • M&A Dynamic: Public companies can use their stock as a currency for acquisitions, facilitating mergers and acquisitions (M&A) activities.

  • Exit Strategy: Going public can serve as an exit strategy for founders, early investors and venture capitalists, providing a means to monetize their investments.

  • Debt Refinancing: IPO proceeds can be used to pay down debt, thereby reducing interest expenses, and improving the company's overall financial position.

  • Growth Potential: Public companies can issue additional shares as a form of currency for future fundraising, potentially supporting further expansion and investment.

  • Enhanced Financial Flexibility: Public companies have access to a broader range of financing options, including issuing bonds, convertible debt, or secondary offerings.

Benefits of an IPO

Going public through an Initial Public Offering (IPO) offers several compelling benefits for companies and their stakeholders. These advantages can vary depending on the company's objectives and circumstances, but they underscore why many companies choose this path:

First, an IPO provides an opportunity for companies to raise capital by issuing shares to the public. This infusion of funds can be used for various purposes, such as financing growth initiatives, expanding operations, paying down debt, or investing in research and development. Access to a broader investor base enables companies to secure the financial resources needed to fuel their ambitions.

Second, an IPO enhances a company's visibility and credibility in the marketplace. Publicly traded companies are subject to regulatory oversight and financial reporting requirements, which can instill added confidence into customers, partners, and suppliers. The increased visibility can also lead to greater brand recognition, further solidifying the company's position in the industry.

Additionally, going public provides liquidity for existing shareholders, including founders, early investors, and employees. Eventually, these stakeholders will have the opportunity to realize the value of their investments and diversify their portfolios by selling their shares on the public market. 

Furthermore, an IPO can facilitate the attraction and retention of top talent. Publicly traded companies often find it easier to recruit and retain top employees by offering stock-based compensation packages. Employees are often motivated by the potential for stock price appreciation and the opportunity to become shareholders, aligning their interests with the company's long-term success.

IPO process

While the exact steps can vary depending on the company and its specific circumstances, the IPO process generally includes the following steps:

1. Company Decision and Preparation

  • Company management and stakeholders, including founders and investors, decide to pursue an IPO.

  • Management engages legal and financial advisors to guide the IPO process.

  • Management prepares financial statements, disclosures, and corporate governance structures to meet regulatory requirements.

2. Select Underwriters and Advisors

  • Management chooses an investment bank/underwriter to manage the IPO. These firms assist with valuation, due diligence, regulatory compliance, and marketing.

  • Management engages legal counsel, auditors, and other professionals to ensure legal and financial compliance.

3. Due Diligence and Documentation

  • Management, in conjunction with the IPO advisors, conducts thorough due diligence to compile historical financial statements, audit reports, and other relevant documents.

  • Management, in conjunction with the IPO advisors, prepares the registration statement and prospectus, which provide detailed information about the company, its operations, management, and risk factors.

4. Financial Reporting and Compliance

  • Management ensures that the company's financial reporting meets regulatory standards, including Generally Accepted Accounting Principles (GAAP).

  • Management creates internal controls and governance structures to comply with securities regulations.

5. Pre-Marketing and Roadshow

  • IPO advisors begin pre-marketing activities to assess investor interest and determine the indicative price range for the IPO.

  • IPO advisors coordinate and conduct roadshows, during which company executives present the business to institutional investors and potential stakeholders.

6. Pricing and Allocation

  • Using investor feedback, the IPO advisors determine a final offering price, and allocate shares to institutional and retail investors. This step aims to balance supply and demand.

7. SEC Review

  • Management, in conjunction with the IPO advisors, submits the registration statement and prospectus to the Securities and Exchange Commission (SEC) for review.

  • Management, in conjunction with the IPO advisors. addresses any regulatory concerns or questions raised by the SEC during the review process.

8. Trading Debut

  • An IPO date is scheduled for the company's shares to be listed and traded on a stock exchange.

  • On the IPO date, the company's shares are made available for public trading. However, the opening market price may differ from the final offering price.

How to invest in an IPO

Investing in an Initial Public Offering (IPO) can be an attractive opportunity to get in on the ground floor of a newly public company. However, securing shares in an IPO can be competitive, and it's essential to approach it strategically. 

Some of the potential steps and tactics used to invest in IPOs are highlighted below. 

1. Stay Informed

  • Keep an eye on financial news, IPO calendars, and announcements of companies going public. Pay attention to the pre-IPO buzz surrounding potential offerings.

2. Research Upcoming IPOs

  • Research the companies planning to go public. Evaluate their financials, business models, growth prospects, and competitive positioning to make informed investment decisions.

3. Assess Your Eligibility

  • Review the eligibility criteria for participating in IPOs. Some IPOs may have restrictions on who can participate.

4. Monitor Your Brokerage's IPO Access

  • Keep an eye on your brokerage's IPO access platform, if available. Many brokerages offer IPO alerts and notifications when new offerings become available.

5. Express Your Interest

  • Indicate your interest in participating in specific IPOs through your brokerage's platform. Some brokerages allow you to submit indications of interest for upcoming offerings.

6. Review Allocation Methods

  • Review how your brokerage allocates IPO shares. Some use a lottery system, while others consider factors like account size, trading activity, or relationship with the brokerage.

7. Diversify Your Bids

  • If possible, diversify your bids across all of the IPOs you are interested in. This can help increase your chances of getting allocated shares in at least one of them.

8. Monitor Allotments

  • Keep an eye on associated IPO allotments. If you are allocated shares, you will need to fund your account to cover the purchase(s). 

9. Access Shares in the Open Market

  • If you aren’t allocated any shares in a given IPO, you can consider buying shares in the open market, after they start trading on the exchange. But it’s important to be mindful of volatility, using limit orders to ensure you only get filled at the prices you intend. 

10. Be Patient and Flexible

  • Understand that not all IPOs are accessible or suitable for every investor. Be patient and flexible in your approach.

11. Manage risk accordingly

  • IPOs can be volatile, and share prices may fluctuate significantly. Be prepared for potential price swings and manage risk in a disciplined manner. 

  • Consider consulting with a professional for additional insight on potential tactics, or the relative attractiveness of a given IPO. 

IPO vs SPAC: what is the difference?

An Initial Public Offering (IPO) and a Special Purpose Acquisition Company (SPAC) merger are both methods for private companies to become publicly traded entities, but they differ significantly in their processes, timelines, and structures.

A SPAC merger, or Special Purpose Acquisition Company merger, is a financial transaction whereby a publicly traded SPAC (which is a shell company with no operations) acquires a private company. Using this process, the private company is able to go public without going through the traditional IPO process. 

Prior to the merger, the SPAC typically raises funds through its own IPO, and then uses those funds to purchase a private company. This process allows the private company to become publicly traded without navigating the complexities of a traditional IPO.

Further details on the differences between a traditional IPO and a SPAC merger are outlined below. 

IPO (Initial Public Offering)

In an IPO, a private company directly goes public by issuing new shares to the public and listing them on a stock exchange.

  • Ownership Structure: In an IPO, the private company retains its existing ownership structure, and new shares are issued to the public. Existing shareholders maintain their ownership stakes.

  • Timing and Process: The IPO process typically involves extensive due diligence, financial reporting, and regulatory compliance. It can be time-consuming and may take several months (or more) to complete.

  • Funds Raised: The funds raised through an IPO go directly to the company. They can be used for a variety of purposes, such as growth initiatives, debt repayment, or research and development.

SPAC (Special Purpose Acquisition Company) Merger

In a SPAC merger, a special purpose acquisition company (SPAC) raises capital through its own IPO with the sole purpose of acquiring an existing private company, effectively taking it public. 

  • Ownership Structure: In a SPAC merger, the private company effectively merges with the SPAC. Existing shareholders of the private company typically receive shares in the merged entity, and the ownership structure may change significantly.

  • Timing and Process: SPAC mergers can often be completed more quickly than traditional IPOs since the SPAC has already gone public and raised capital. The merger process can take several months, but it may be faster and less onerous than conducting a standalone IPO.

  • Funds Raised: The funds raised through the SPAC's IPO are held in a trust and used specifically for the acquisition of the private company. These funds are typically used to buy the private company's shares and facilitate the merger.

IPO vs Direct listing: what is the difference?

A direct listing is a method by which a private company becomes publicly traded by allowing its existing shares to be traded on a stock exchange without issuing new shares or raising capital. 

In a direct listing, the company's shareholders are often allowed to immediately sell their existing shares to the public. This approach provides liquidity for existing shareholders and allows the company to go public without the traditional underwriting process and associated costs of an initial public offering (IPO).

Additional details on the difference between IPOs and direct listings are highlighted below. 

IPO (Initial Public Offering)

In an IPO, a private company issues new shares to the public and raises capital through the sale of those shares. 

  • Funds Raised: In an IPO, the company raises fresh capital by issuing new shares to investors, which can be used for various purposes, such as expansion, debt reduction, or research and development.

  • Underwriting: The IPO process typically involves the engagement of underwriters (investment banks) to facilitate the offering, determine the offering price, and ensure the successful distribution of shares to investors.

  • Disclosure and Regulatory Compliance: Companies going through an IPO are subject to rigorous regulatory requirements, including financial reporting, due diligence, and extensive disclosure obligations to the Securities and Exchange Commission (SEC) and other regulatory bodies.

  • Lock-Up Periods: Insiders, including founders and early investors, often have lock-up agreements that restrict them from selling their shares for a specified period following the IPO.

Direct Listing

In a direct listing, a private company becomes publicly traded by allowing its existing shares to be traded on a stock exchange without issuing new shares or raising capital. 

  • Funds Raised: Unlike an IPO, a direct listing does not involve the creation or sale of new shares, and therefore, the company does not raise capital through the process.

  • No Underwriters: Direct listings do not require underwriters, eliminating the need for the underwriting process and associated fees. The company sets its initial reference price, but the opening market price is determined by supply and demand.

  • Regulatory Compliance: While both IPOs and direct listings must adhere to regulatory and reporting requirements, direct listings typically involve fewer regulatory hurdles and a simplified approval process.

  • Liquidity for Existing Shareholders: Existing shareholders, including employees and early investors, often have the opportunity to sell their shares directly to the public, providing liquidity without a lock-up period.

  • Price Discovery: The opening market price in a direct listing is determined by the exchange and market participants, potentially leading to elevated price volatility after the direct listing starts trading. 

Who can invest in an IPO?

In general, virtually anyone can invest in an initial public offering (IPO) unless they are specifically prohibited due to regulatory restrictions, or limitations set by the issuing company and/or underwriters. 

As such, IPOs are typically open to a wide range of investors, including individual retail investors, institutional investors, company employees, founders, early investors, and others. However, there may be certain conditions or restrictions that can affect an individual's ability to participate in a particular IPO. 

In some cases, IPO allocations may be limited, and not all retail investors may have access to participate in every IPO. Additionally, IPO shares may be in high demand, making the allocation process competitive, and as a result, interested investors may not receive the number of shares they desire (if any). 

Additional details are highlighted below:

  • Individual Investors: Individual investors, both retail and high-net-worth, can often participate in IPOs. 

  • Institutional Investors: Institutional investors, such as mutual funds, pension funds, hedge funds, and asset management firms, frequently participate in IPOs, often acquiring significant allocations of shares.

  • Company Employees: Many companies offer their employees the opportunity to purchase IPO shares at the offering price or through employee stock purchase plans.

  • Founders and Early Investors: The founders and early investors of the company undergoing the IPO may also participate in the offering, either by selling their shares or acquiring additional shares.

  • Underwriters and Brokers: Investment banks and underwriters involved in the IPO process may have the option to purchase shares at the offering price and then distribute them to their clients or trading desks.

Is it worth investing in IPOs?

Investing in initial public offerings (IPOs) can be a viable strategy, but it's essential to approach it with a clear understanding of the specific offering and your investment objectives. The decision to invest in an IPO is fundamentally no different from any other investment—it hinges on your research and outlook for the stock in question.

When considering an IPO, the key is to thoroughly evaluate the company's fundamentals and growth potential. Take a close look at factors like the company's business model, competitive positioning, industry trends, and the experience of its management team. Assess whether the IPO aligns with your investment goals, risk tolerance, and time horizon.

It's important to remember that IPOs, like any investment, carry risks. The stock's performance will be influenced by market sentiment and broader economic conditions. While some IPOs can offer significant returns, they can also be associated with increased volatility. Therefore, effective risk management and a long-term perspective are crucial when evaluating a potential IPO investment. 

IPOs summed up

IPOs, or initial public offerings, are a pathway for private companies to go public by offering shares to the public and listing them on stock exchanges. Investing in IPOs can be a compelling strategy for those seeking growth opportunities and diversification within their investment portfolios. However, success in IPO investing hinges on thorough research and a clear outlook for the specific IPO in question.

When evaluating an IPO, it's essential to delve into the company's fundamentals, assessing its business model, competitive positioning, management team, and growth potential. Additionally, consider whether the IPO aligns with your overall investment objectives, risk tolerance, and investment horizon. Keep in mind that IPOs can be influenced by market sentiment and broader economic conditions, which can lead to price fluctuations.

To succeed in IPO investing, exhaustive research and effective risk management are vital. While IPOs offer the potential for significant returns, they also carry inherent risks. Therefore, IPOs should be integrated into a well-informed and diversified investment strategy that considers both short-term and long-term objectives.

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