What is an IPO? Initial Public Offering Explained | Beginner’s Guide

This guide will investigate the initial public offering or IPO. It will delve into the process of a company “going public,” how retail investors can get in on the action, as well as the pros and cons of investing in these types of stocks.

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What is an IPO stock?

IPO stands for initial public offering and is the process of a privately owned company listing its shares on a stock exchange, making them available for the investing public for the first time.

The IPO process allows the offering company to raise capital from public investors to expand operations and fuel growth. In addition, an IPO can be seen as an opportunity for early-stage investors and founders to cash in, as it typically includes a share premium for existing private investors.

In order to “go public,” a private company hires an investment bank (or several) to underwrite the IPO. Typically in an underwriting agreement, the underwriter agrees to bear the risk of purchasing the entire inventory of shares issued in the IPO before they are sold to the public at the IPO price. Often, to ensure widespread distribution of the new IPO shares, a group of underwriters, called the syndicate, shares in the risk for the offering.

The role of an underwriter is to serve as the intermediary between the company and investors, as well as work with the company to ensure that all regulatory requirements are satisfied. In particular, the underwriters must navigate the process of filing a registration statement with the Securities and Exchange Commission (SEC), which includes its prospectus with detailed information on the company’s finances, business model, and growth opportunities.

Then, to gauge interest in the stock, IPO specialists contact an extensive network of investment organizations—such as mutual funds, pension funds, foundations, and insurance companies. The amount of interest these large institutional investors receive helps their underwriters set an initial public price and issuance date.

Finally, on IPO day, the company “goes public” as the company’s stock becomes available to the general public, beginning trading on a major stock exchange like the NASDAQ or New York Stock Exchange (NYSE).

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The IPO process

Getting a company to its IPO is time-consuming, expensive, and teeming with regulatory hurdles. For example, to go public, a company must open its records to public scrutiny, as well as examination by SEC regulators.

The IPO process consists of the pre-marketing phase of the offering and the initial public offering itself, involving the following steps:

• Selecting an underwriter: The first step is for the issuing company to pick an underwriter. The underwriter is typically an investment bank that operates with IPO specialists such as lawyers, certified public accountants (CPAs), and SEC experts. The underwriter’s job is to assess the firm through financial analysis and come up with a valuation, share price, and a date for the IPO, as well as ensure that the company satisfies all regulatory requirements. They also guarantee that a specific amount of shares will be sold at that initial price and purchase any excess;
• Documentation: The underwriter then files the S-1 registration statement with the SEC, outlining the planned use of capital raised by the IPO, detailing the current business model and competitors, and presenting a brief prospectus of the offering itself. It will then be revised as needed throughout the pre-IPO process;
• Marketing: Before an IPO opens to the public, the company seeks to drum up excitement for the IPO through roadshows (a series of presentations given to investors in various locations). A successful roadshow can drive demand for the stock and raise more capital;
• Going public: Once the company’s registration statement is declared “effective,” and the underwriter has priced the shares, trading can begin on a stock exchange like Nasdaq or the New York Stock Exchange;
• Stabilization: In an IPO, underwriters stabilize the stock price by buying its shares at the offer price on the secondary market. By increasing demand, the underwriters can prevent the stock’s price from falling. In addition, in the case of higher demand, underwriters can also increase supply through the greenshoe option, which allows for the selling of up to 15% more shares than the original issue amount;
• Quiet period: With an IPO, the quiet period extends from when a company registers with the SEC to 40 days after the stock starts trading. During these periods, the company’s management and marketing teams are barred from talking to the public about their firm to preserve objectivity and avoid the appearance of insider information. The purpose of this period is to ensure all investors get a “fair shake” by assuring they have access to the same information at the same time;
• Transition to market competition: The end of the quiet period starts the final stage of the IPO process, the transition to market competition, as investors transition from relying on the prospectus for information on the stock to relying on market forces.

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How to invest in an IPO?

Gaining access to an IPO before it begins trading can be challenging. However, should you decide to take the chance, follow these four steps: