Some business owners may dream of someday ringing the bell on the New York Stock Exchange and celebrating with an expensive bottle of champagne after a wildly successful IPO.
What is an IPO? An IPO, or initial public offering, refers to the process whereby a privately-owned company offers shares of stock for sale to the general public for the first time.
“Going public” has benefits—it may boost a company’s profile, bring prestige to the management team, and raise a significant amount of cash that can be used for business expansion.
Just as an IPO has upsides, there are downsides to going public as well. An IPO is a costly and time-consuming process and can subject the business to a high level of scrutiny.
And just as there are upsides and downsides for a business going public or staying private, there are pros and cons for folks who are considering investing in a company’s IPO.
What is an IPO (Initial Public Offering)?
An initial public offering (IPO) refers to the first time a company offers shares of stock to the general public. A company is not legally allowed to sell stock to the public until the transaction has been registered with the Securities and Exchange Commission (SEC) or procures an exemption.
Prior to an IPO, a company is “private,” which means that shares of stock are not available for sale to the general public. Also, a private company is not generally required to disclose financial or business information to the public. A company that goes through the IPO process is often referred to as a “public company.” The IPO process itself is sometimes called “going public.”
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To register an IPO , a company files a registration statement with the SEC, including a prospectus. The company will use the prospectus to solicit investors and includes key information like the terms of the securities offered and the business’s overall financial condition.
Behind the scenes, much work is done to get to the point where the business registers an IPO with the SEC. Registering an IPO is a costly process, and usually requires an entire team of lawyers, accountants, and underwriters. Underwriters generally are responsible for creating the financial terms of an IPO.
The underwriters at the investment bank help the company to determine the type of securities to issue, the offering price, the number of shares, and any other relevant details for the market offering.
When the company makes their SEC filing, they’ll generally do so in tandem with an application to list their stock on one of the stock exchanges, like the New York Stock Exchange or NASDAQ. According to the
SEC , “Any planned exchange listing will typically be disclosed in the prospectus for the IPO.”
Why Does A Company IPO?
Answering the question, “what’s an IPO?” doesn’t explain why a company “goes public”—an important detail in the process. Because an IPO requires a significant amount of time and resources, a business probably has good reason to go through the trouble. While there are a handful of reasons to have an IPO, a common reason is to raise capital (money) for possible expansion.
Prior to registering an IPO, a private company may procure funding through angel investors, venture capital, private investors, and so on. A company may reach a size where it is no longer able to procure enough capital from these sources to fund further expansion. Offering sales of stock to the public may allow a company to access this rapid influx of investment capital.
Pros and Cons of an IPO
As with any business decision, there are downsides and risks to going public that should be considered in conjunction with the potential benefits. Here’s a look at a few :
1. A company’s public offering may provide an opportunity to raise capital on a scale that might not be possible with other forms of capital generation. This is capital that can be used for business expansion, infrastructure buildout, intensive research, or other activities that require a large amount of upfront cash.
2. An IPO may expand opportunities for future access to capital. They can issue more stock, and may also be able to attract business partners, potential investors, or other opportunities that would not exist for a company that has not publicly filed their financial information with the SEC.
3. An IPO may increase liquidity for a company’s stock, which could allow owners and employees to sell stock more easily.
4. In some cases, publicly-traded stocks can be used as currency. For example, stocks may allow a business to compensate employees with stock and stock options offers. This may help a business to attract top talent for executive roles.
5. Having publicly-traded stocks can be useful in mergers and acquisitions. A company may be able to acquire other businesses by using their stock as payment.
6. An IPO can create publicity and brand awareness for a company. Also, there’s no denying that an IPO provides some prestige for a business.
1. Going public is expensive and time-consuming. For some businesses, like smaller business or businesses with limited revenue, an IPO may not be worth the cost and effort. Every company should consider conducting an extensive cost-benefit analysis prior to pursuing an IPO.
2. A public company’s initial disclosure obligations may begin with the registration statement they file with the SEC, but that is far from the only filing requirement. Public companies must continue to keep their shareholders informed on a regular basis by filing periodic reports and other materials.
A public company takes on significant new obligations, such as filing quarterly and annual financial reports with the SEC, keeping shareholders and the market informed, and running extensive internal controls tests required by the Sarbanes-Oxley Act of 2002 .
These obligations can take up a significant amount of time, which may limit a management team’s ability to tend to actual matters of business.
3. A company and its management may be liable if legal obligations (such as filing quarterly and annual financial statements) are not satisfied.
The Sarbanes-Oxley Act strengthened requirements for reporting practices at public companies. For example, top managers must certify the accuracy of financial reports. If a top manager knowingly makes a false certification, they could face time in prison.
4. A private company will generally report to a smaller group of investors and has more control over who those investors are. Management at a publicly-owned company, who may have to consider the opinions of shareholders, may lose some managerial flexibility.
5. When a company is public, they are required to share important information about the business, such as financial statements and disclosures, contracts, and customers and suppliers. This exposes a company to a considerable amount of scrutiny.
This information is also available to a business’s competitors.
Is an IPO a Good Investment?
An IPO, by definition, gives the investing public an opportunity to own the stock of a newly public company. However, the SEC warns that IPOs can be risky and speculative investments.
To understand why, it is helpful to know that the company’s offering price “may bear little relationship to the trading price of the securities” and that “it is not uncommon for the closing price of the shares shortly after the IPO to be well above or below the offering price.”
This happens because the offering price is determined not by the market forces of supply and demand, as is the case for stocks trading openly in a market exchange, but because the company and the underwriters negotiate a price based on an often-competing set of interests of involved parties.
Purchasing shares in the market immediately following an IPO can also be risky. “Underwriters can support the trading price of the new issue in its first few days of trading with certain trading activities, including purchasing shares of the company.” Underwriters may do this to buoy the trading price, keeping it from falling too far below the offering price. The concern to investors is what happens to the price once this support ends.
Getting into IPOs Early
Even if an investor were to feel comfortable with the risk, they may not have access to the stock being offered in an IPO. IPO investing is sometimes limited to those with access to the investment bank that acts as the IPO’s underwriter.
If an investor is a client of an underwriter involved in the IPO, they may have the opportunity to directly participate in the IPO by purchasing the shares. Usually, though, underwriters will distribute IPO shares to their “institutional and high net-worth clients, such as mutual funds, hedge funds, pension funds, insurance companies, and high net-worth individuals.”
Therefore, the average investor may not have the chance to “get in on the ground floor.” Instead, investors may try accessing shares in the “secondary market,” which is another name for the stock exchange, in the days following an IPO. An investor could try to buy shares of a recently-public company through their brokerage bank or online investing platform as they become available.
Investors with the option to invest in an IPO should do so only after having conducted their due diligence. The SEC states that “being well informed is critical in deciding whether to invest. Therefore, it is important to review the prospectus and ask questions when researching an IPO.”
Investors should receive a copy of the prospectus before their broker confirms the sale. To read the prospectus before then, check with the company’s most recent registration statement on EDGAR .
The SEC reminds investors that just because an IPO is cleared to move forward with the process, it does not necessarily mean that the IPO or the company is a good investment. In addition to reading a company’s prospectus, investors may want to consider a company’s risk factors, dividend policy, use of investment capital, dilution, and sections in their filing titled “selected financial data,” “management’s discussion and analysis,” “business,” and “financial statements and notes.” Further, an investor may want to compare this information to independent analyses of an IPO.
Again, it may not even be feasible for a typical, individual investor to access an IPO. Instead, individual investors may look to buy shares of stock as they trade on the secondary exchange via their preferred method of stock investing.
Adding IPO Stocks to Your Portfolio
Investors may also want to consider diversifying their portfolios. That way, the performance of any one given stock, whether newly public or not, will not derail the performance of the entire investment portfolio.
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