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What Is an IPO?

By Inyoung Hwang · May 12, 2021 · 8 minute read

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What Is an IPO?

An IPO, or initial public offering, refers to the process of privately-owned companies selling shares of the business to the general public for the first time.

“Going public” has benefits: it can boost a company’s profile, bring prestige to the management team, and raise cash that can be used for expanding the business.

But there are downsides to going public as well. The IPO process can be costly and time-consuming and subject the business to a high level of scrutiny.

Meanwhile, for folks who are considering investing in a company’s IPO, there are pros and cons. Here’s a deep dive into IPOs.

How IPOs Work

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).

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 information to the public.

To have an IPO, a company must file a prospectus with the SEC. The company will use the prospectus to solicit investors, and it includes key information like the terms of the securities offered and the business’s overall financial condition.

Behind the scenes, companies typically hire investment bankers and lawyers to help them with the IPO process. The investment bankers act as underwriters, or buyers of the shares from the company before transferring them to the public market. The underwriters at the investment bank help the company determine the offering price, the number of shares that will be offered, and other relevant details.

The company will also apply to list their stock on one of the different stock exchanges, like the New York Stock Exchange or Nasdaq Stock Exchange.

History of IPOs

While there are some indications that shares of businesses were traded during the Roman Republic, the first modern IPO is widely considered to have been offered by the Dutch East India Company in the early 1600s. In general, the Dutch are credited with inventing the stock exchange, with shares of the Dutch East India Company being the sole company trading in Amsterdam for many years.

In the U.S., Bank of North America conducted the first American IPO, which likely took place in 1783. A report claims investors hiding cash in carriages evaded British soldiers to buy shares of the first American IPO.

Henry Goldman led investment bank Goldman Sachs’ first IPO–United Cigar Manufacturers Co.– in 1906, pioneering a new way of valuing companies. A challenge for retail companies at the time was that they lacked hard assets, as other big businesses like railroads had at the time. Goldman pushed to value companies based on their income or earnings, which remains a key part of IPO valuations today.

Recommended: A Brief History of the Stock Market

IPO Investing at Your Fingertips
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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.

Raising Money

A common reason is to raise capital (money) for possible expansion. Prior to an IPO, a private company may procure funding through angel investors, venture capitalists, 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.

Exit Opportunity

An IPO may be a way for early stakeholders, such as angel investors and venture-capital firms, to cash out of their holdings. Venture-capital firms in particular have their own investors that need to provide returns for. IPOs are a way for them to transfer their share of a private company by selling their equity to public investors.

More Liquidity

Venture-capital firms and angel investors aren’t the only ones who may be seeking more liquidity for stakes in companies. Liquidity refers to the ease with which an investor can sell an asset. Stocks tend to be much more liquid assets than private-company stakes.

Hence, employees with equity options can also use IPOs as a way to gain more liquidity for their holdings, although they are usually subject to lock-up periods.

Publicity

From the roadshow that investment banks hold to inform potential investors about the company to when executives may ring the opening bell at a stock exchange, an IPO can bring out greater publicity for a company.

Being listed as a public company also exposes a business to a wider variety of investors, allowing the business to obtain more name recognition.

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:

Pros

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.

3. An IPO may increase liquidity for a company’s stock, which could allow owners and employees to exercise options and sell shares more easily.

4. 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.

5. 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.

Cons

1. Going public is expensive and time-consuming. 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.

3. A company and its management may be liable if legal obligations (such as filing quarterly and annual financial statements) are not satisfied.

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.

IPO Alternatives

Since the heady days of the dot-com bubble, when many new companies were going public, startups have become more disgruntled with the traditional IPO process. Some of these businesses often complain that the IPO model can be time-consuming and expensive.

Particularly in Silicon Valley, the U.S. startup capital, many companies are taking longer to go public. Hence, the emergence of so many unicorn companies–businesses with valuations of $1 billion or greater.

In recent years, alternatives to the traditional IPO process have also emerged. Here’s a closer look at some of them.

Recommended: Guide to Tech IPOs

Direct Listings

In direct listings, private companies skip the process of hiring an investment bank as an underwriter. A bank may still offer advice to the company, but their role tends to be smaller. Instead, the private company relies on an auction system by the stock exchange to set their IPO price.

Companies with bigger name brands that don’t need the roadshows tend to pick the direct-listing route.

SPACs

Special purpose acquisition companies or SPACs have become another common way to go public. With SPACs, a blank-check company is listed on the public stock market.

These businesses typically have no operations, but instead a “sponsor” pledges to seek a private company to buy. Once a private-company target is found, it merges with the SPAC, going public in the process.

SPACs are often a speedier way to go public. They became wildly popular in 2020 and 2021 as many famous sponsors launched SPACs.

Recommended: Why Are SPACs Suddenly So Hot

Crowdfunding

Crowdfunding is collecting small amounts of money from a bigger group of individuals. The advent of social media and digital platforms have expanded the possibilities for crowdfunding.

One 2020 report found that $17.2 billion is generated in North America annually through crowdfunding. The average crowdfunding campaign has raised $824, with the average pledge by a backer by $88.

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.

IPO Market Price

To understand why investing in an IPO can be risky, it is helpful to know that the business valuation and offering price have not been determined not by the market forces of supply and demand, as is the case for stocks trading openly in a market exchange.

Instead, the offering price is usually determined by the company and the underwriters who negotiate a price based on an often-competing set of interests of involved parties.

Post-IPO Trading

Purchasing shares in the market immediately following an IPO can also be risky. Underwriters may do what they can to buoy the trading price initially, keeping it from falling too far below the offering price.

Meanwhile, IPO lock-up periods may stop early investors and company executives from cashing out immediately after the offering. The concern to investors is what happens to the price once this support ends.

Data from Dealogic shows that since 2010, a quarter of U.S. IPOs have seen losses after their first day.

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.

Recommended: How to Invest in IPOs

IPO Due Diligence

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’s public filing system.

The Takeaway

Initial public offerings or IPOs are a key part of U.S. capital markets, allowing private businesses to enter the world’s biggest public market. Conducting an IPO is a multi-step, expensive process for private companies but allows them to significantly expand their reach when it comes to fundraising, liquidity and brand recognition.

For investors, buying an IPO stock can be tempting because of the potential of getting in on a company’s growth early and benefiting from its expansion. However, it’s important to know that many IPO stocks also tend to be untested, meaning their businesses are newer and less stable and that the stock price hasn’t been fully vetted by scrutinizing public investors yet.

SoFi Invest® now offers a new IPO investing feature that allows members to access IPO shares before they get listed on the public stock market. That means eligible individual investors who have an Active Investing account with SoFi can buy shares at the IPO price before they’re trading on exchanges. This opportunity has traditionally only been available to institutional investors.

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