For new investors, 'IPO' is a term you will have heard a lot in recent years -- but what exactly is an IPO and why do they matter to you?
Nov. 14, 2022
An Initial Public Offering, or 'IPO', refers to the process of a private company offering its shares on a publicly traded exchange. Also referred to as 'taking the company public', this process allows a corporation to raise capital by making shares in the company available to public investors.
The first ever modern IPO is credited to the Dutch East India Company which made its shares available for public sale in 1602. Since then, thousands of companies have gone public.
Apple, Microsoft, Tesla, and so many more of the biggest names on Wall Street all went public at some point, which is why we are able to invest in them now.
What is the IPO process?
The first step in taking the company public is through underwriting due diligence, where a third-party individual or financial institution -- such as Wells Fargo or Goldman Sachs -- assumes a portion of the company's financial risk when going public. If the IPO goes well, they will also take a part of the profit. Underwriting involves conducting research and assessing the degree of risk of each applicant or entity before assuming that risk.
The company must then meet the requirements of the Securities and Exchange Commission (SEC) as well as the exchange they wish to list on, whether it be Nasdaq or the New York Stock Exchange. An S-1 Registration statement is the primary IPO filing document and contains the company's prospectus -- information on its path to profitability and how much it will grow, almost like a 5-year plan -- and its privately held filing information.
Before going public, the companies 'price per share' must then be determined. This can be done in one of two ways:
1. The company and its leading managers fix a price itself in what is known as a 'fixed price offering', meaning investors know the price before the company goes public.
2. Otherwise, the price can be determined through analysis of confidential investor demand data compiled by the bookrunner, known as 'book building'.
Then, a board of directors must be formed and a process established for the company to report auditable financial and accounting information every quarter. After that it's all about picking a date to go public.
Advantages of an IPO
As we know, there are other ways to take a company public such as a 'direct listing', which is when the company is taken public without any underwriters. This means that the company going public and issuing the shares assumes all the risk. There is also the lesser-known 'Dutch Auction', where shares literally go to the highest bidder. Google did this in 2004 in lieu of a traditional IPO and it worked out ok for them.
So what are the advantages of a traditional IPO?
- One of the most important advantages of an IPO is that it raises a lot of money for a company which can then be used for expansion or even paying off debts.
- An IPO also allows the founders and owners of the company to cash out for a big payday, either by selling shares at higher prices than their initial investment or by claiming more stock for themselves.
- Shares can be a useful currency in the case of acquisitions and mergers, as they can be offered in lieu of cash when a company wishes to purchase another. For example: In 2017, Disney announced its acquisition of most of 21st Century Fox assets in an all-stock deal valued at $52 billion.
- Having stock options also allows a company to attract top talent, allowing them to pay executives relatively low wages with the promise of cashing out on their stocks for a big payday later on. Of course, the payday all depends on how well the company does.
Disadvantages of an IPO
It's not all sunshine and rainbows though, as seen by some disappointing IPO performances in recent years, which included Uber, Lyft, and SmileDirectClub.
- An IPO requires a lot of money and a lot of work, which can distract important personnel within the company from their business. This can hurt profits, as well as the costs involved in hiring investment banks and completing legal formalities.
- Sometimes, a board of directors will not want the founder of the business to keep their shares. This is because the company's stock price movement could be affected by that founder's own decisions, such as selling stock. Imagine if Warren Buffett sold half his Berkshire shares tomorrow -- it wouldn't inspire much confidence.
- The founder and/or owner can lose control of the business they built, just because the new board of directors has that power. Just look at what happened to Apple after it fired Steve Jobs in the '80s, or imagine what would happen if Amazon fired Jeff Bezos?
- A public company is also just that: public! It loses any privacy and must release valuable information every quarter, which can distract from the company's long-term vision. A lot of details about the company's business and its owners become public.
What is the purpose of an IPO?
The purpose of an IPO is to raise money from outsiders in a manner that provides the funders with a predefined and very limited set of rights.
How does an IPO make money?
A bank or group of banks put up the money to fund the IPO and 'buys' the shares of the company before they are actually listed on a stock exchange.
