What is an IPO?

An Initial Public Offering (IPO) marks a significant milestone for a company, representing its first foray into the public market by offering shares of its stock to the general public¹. Before an IPO, a company is considered private, meaning that its shares are not available for purchase on public stock exchanges. IPOs are typically underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges¹. Through this process, colloquially known as “floating” or “going public,” a privately held company transforms into a public company¹. It’s important to distinguish between the terms “going public” and the “IPO process.” While an IPO is a common way for a company to go public, it’s not the only option².

It’s worth noting that the concept of a company issuing public shares has a long history, dating back to the Roman Republic. During this period, entities called “publicani” operated as legal bodies with ownership divided into shares, similar to modern joint-stock companies¹.

In addition to the initial public offering, there are other types of offerings related to publicly traded companies:

• Follow-on offering: This refers to an issuance of additional shares of stock by a company that is already publicly traded. Follow-on offerings can have a dilutive effect on an individual’s position as new shares are issued³.
• Secondary offering: This involves a registered sale of previously issued securities held by large investors, such as a private equity firm or other institution. Secondary offerings do not have a dilutive effect on an individual’s position as the shares were previously issued³.

Why do companies go public?

Companies choose to go public through an IPO for a variety of reasons, with the primary motivation often being to raise capital⁴. By selling shares of the company to the public, organizations can generate significant funds to fuel various aspects of their operations, such as:

• Investing in growth and expansion ⁴
• Paying off existing debt ⁴
• Funding research and development ⁴

In essence, an IPO is a form of equity financing, where a percentage of ownership in the company is exchanged for capital. This contrasts with debt financing, where the company borrows money and is obligated to repay it with interest⁵.

Beyond raising capital, going public offers several other advantages:

• Increased visibility and prestige: An IPO can significantly raise a company’s profile, attracting attention from media outlets and investors. This heightened visibility can make the company more appealing to customers, partners, and potential employees⁶.
• Creating liquidity for existing shareholders: An IPO provides an opportunity for early investors and employees who hold private shares to sell their holdings and realize a return on their investment. This can be a significant incentive for individuals who have contributed to the company’s early growth⁷.
• Facilitating acquisitions: Publicly traded companies gain a valuable tool for growth through acquisitions. They can use their stock as currency to acquire other companies, often at more favorable terms than if they were using cash⁷.
• Improving corporate governance: The process of going public often leads to improvements in a company’s corporate governance. Public companies are subject to stricter regulations and reporting requirements, which can enhance transparency and accountability⁷.
• Encouraging a focus on profitability: Going public can incentivize managers to prioritize profitability and efficient operations. The need to meet shareholder expectations and maintain a positive public image can drive a stronger focus on financial performance⁸.

It’s important to understand that companies have various options for raising capital, and an IPO is just one of them. Here are some common ways companies can raise funds:

• Public issue: Selling securities to the public through an IPO⁹.
• Rights issue: Offering new securities to existing shareholders⁹.
• Private placement: Approaching institutional investors for funding⁹.
• Preferential allotment: Selling securities to select investors⁹.

Recent IPOs and their performance

The IPO market tends to be cyclical, with periods of high activity followed by periods of lower activity¹⁰. Several factors can influence the level of IPO activity, including overall market conditions, investor sentiment, and the availability of promising companies seeking to go public.

Recent data indicates a strong IPO market in 2024, particularly in the United States. The US IPO market experienced significant growth in 2024, with a notable increase in both the number of IPOs and the proceeds raised¹⁰. The health care and technology sectors were particularly active, accounting for a significant portion of the IPOs¹⁰.

However, it’s crucial to remember that past performance is not necessarily indicative of future results¹¹. While some recent IPOs have generated substantial returns for investors, others have not performed as well¹². The performance of an IPO can be influenced by a variety of factors, including the company’s financial health, market conditions, and investor sentiment.

How does the IPO process work for companies?

The IPO process can be a complex and time-consuming endeavor, often taking several months to complete¹³. It generally involves two main parts: the pre-marketing phase and the IPO itself¹⁴. Here’s a breakdown of the key steps involved:

1. Select an investment bank: The company begins by selecting an investment bank to act as the lead underwriter for the IPO. The underwriter plays a crucial role in guiding the company through the entire IPO process, providing expertise in areas such as due diligence, pricing, and marketing the offering to potential investors¹⁵.
2. Due diligence and documentation: The underwriter conducts thorough due diligence on the company, reviewing its financial health, legal compliance, and overall business operations. This process ensures that the company meets all regulatory requirements and provides potential investors with a clear understanding of the company’s fundamentals¹⁵. This stage also involves preparing essential documentation, including the registration statement that will be filed with the Securities and Exchange Commission (SEC)¹⁴.
3. IPO filings and pricing: The company files a registration statement with the SEC, a key document that includes a prospectus providing detailed information about the company and the offering¹⁵. The underwriter works closely with the company to determine the IPO price, taking into account factors such as the company’s financial performance, market conditions, and investor demand¹⁵. There are two primary approaches to pricing an IPO:

• Fixed Price IPO: The company sets a fixed price for its shares before the IPO. Investors are aware of the price when they apply for shares¹⁶.
• Book Building: The company offers a price range for its shares, and investors bid on the shares before the final price is determined¹⁶.

4. Marketing and roadshow: To generate interest in the IPO, the underwriter and company management often embark on a “roadshow,” a series of presentations to potential investors. This roadshow allows the company to showcase its strengths and growth prospects, aiming to attract investors and build momentum for the IPO¹⁴.
5. Going public: Once the SEC approves the registration statement, the company’s shares begin trading on a stock exchange. This marks the official transition from a private to a public company¹⁵.
6. Stabilization: After the IPO, the underwriter may engage in activities to stabilize the price of the stock in the aftermarket. This can involve buying and selling shares to ensure a smooth transition into the public market¹⁵.

Underwriting Spread

The underwriters involved in an IPO receive compensation for their services in the form of an underwriting spread. This spread is a percentage of the proceeds from the IPO and is typically deducted from the sale of the shares¹. The components of an underwriting spread generally include:

• Manager’s fee: This fee is paid to the lead underwriter for managing the IPO process.
• Underwriting fee: This fee is earned by the members of the syndicate, the group of investment banks involved in the IPO.
• Concession: This fee is earned by the broker-dealers who sell the shares to investors¹.

How can individuals invest in an IPO?

Now that we’ve looked at the IPO process from a company’s perspective, let’s explore how individuals can participate in an IPO. Investing in an IPO can be an appealing opportunity to get in on the ground floor of a promising company and potentially benefit from its future growth¹¹. However, it’s essential to approach IPO investing with a clear understanding of the potential risks and rewards involved.

Here are some key considerations for individuals interested in investing in an IPO:

• Do your research: Before investing, it’s crucial to conduct thorough research on the company and the IPO itself. Carefully review the company’s prospectus, which provides detailed information about its financial performance, business operations, and risk factors. Consulting with a financial advisor can also be helpful in making informed investment decisions¹⁷.
• Understand the risks: IPOs can be inherently risky investments. There’s no guarantee that the stock price will rise after the IPO, and in some cases, it may decline significantly¹¹. Factors such as market sentiment, company performance, and broader economic conditions can all influence the price of an IPO stock. It’s important to be aware of the potential for both significant gains and losses³. While IPOs can be lucrative, there’s also a downside risk of overvaluation, where the initial price may not accurately reflect the company’s true value⁵.
• Be prepared to hold for the long term: IPOs are often considered long-term investments. The initial trading days can be particularly volatile, and it may take time for the stock price to stabilize and reflect the company’s true potential¹¹.
• Be aware of share allotment: In oversubscribed IPOs, where demand for shares exceeds the number of shares offered, there’s no guarantee that you will be allotted shares¹⁸. Brokerage firms often have limited allocations of IPO shares, and they may prioritize their larger or more active clients.
• Access to IPO shares: Licensed securities salespeople play a role in distributing IPO shares to individual investors. These salespeople, who are registered representatives in the US and Canada, receive a portion of the selling concession as compensation for selling IPO shares to their clients¹.

Works cited

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