Before listing a stock for sale on a public exchange, companies undergo a rigorous process of preparation and compliance. In addition to providing the Securities and Exchange Commission (SEC) and the public with a detailed prospectus about their team, background, and finances, companies must come up with a suggested starting price for each share they plan to sell in their initial public offering (IPO). This price then creates an IPO valuation for the company.
Companies and their bankers use a variety of factors and steps to determine the IPO price. Here’s a closer look at the IPO valuation process.
What Is IPO Price?
An IPO price is the price at which a company’s stock is sold to accredited and institutional investors right before the stock trades on an exchange. The purpose of the public offering price is to attract investors to buy the shares. The investment banks that underwrite a company’s public offering set the IPO price.
The investment bankers that underwrite a company’s public offering use several variables to determine the IPO price, including an analysis of the company’s growth potential, a comparison to related firms, and a determination of market demand conditions.
Initial Public Offerings 101
When privately-owned companies, such as unicorn companies, begin to sell shares of stock to the public, they hold an initial public offering, or IPO. Before an IPO, companies are usually owned by the founders, employees, and early investors, such as venture capital firms and angel investors. The process of selling shares to investors is called going public.
An IPO can help a company raise significant capital. They can also be a source of publicity. However, the IPO process is also time-consuming and expensive. Once a company has gone public, it faces new challenges such as regulatory scrutiny and an increased need to please shareholders.
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Why Do Companies Go Public?
The main reason companies choose to go public is to raise money. Holding an IPO can create significant value for a company and its management. In many cases, IPOs raise millions and even billions of dollars for the company.
Bringing in public investment benefits the business, but it also benefits early investors. These initial investors, who have invested time and money in a company, can sell their shares following an IPO, unlocking shareholder value
An IPO can also benefit employees of the company. That’s because when an individual joins a company, sometimes they are granted employee stock options. Companies will often give early employees the options over several months or years — a process called vesting. Usually, employees must wait to sell their vested stock until the end of a lock up period — a period after an IPO during which employees have to wait before selling their shares.
Other reasons companies go public are to gain media attention, grow a broad base of financial supporters, and create a windfall for venture capital firms that helped fund the company in its early stages.
The number of publicly traded, exchange-listed companies in the U.S. has decreased from the peak in the mid-to-late 1990s when it reached about 8,000. In 2021, the figure was closer to 6,000 companies that traded on different stock exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq.
Steps in IPO Valuation
How Underwriting Works in IPOs
When a company decides to hold an IPO, they work with an investment bank to determine the company’s IPO valuation. The process of investment bankers handling an IPO is called underwriting. Each underwriting process can be slightly different, but investment bankers’ factors in determining IPO prices and valuations are essentially the same. Some questions include:
• Why has the company decided to go public?
• What is the current status of the market?
• Who are the company’s competitors?
• What are the company’s assets?
• How much has been invested in the company and by whom?
• What is the history of the company and its team?
• What are the company’s prospects for growth?
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Process of Determining IPO Prices
The rules of supply and demand apply to how the company and its underwriters will set an IPO price. Essentially, the underwriters must determine the demand for the shares based on the supply of shares that will be offered and sold to investors. These underwriters try to figure out what investors are willing to pay for each share of a company when it decides to go public.
To create a balance in this tradeoff that makes both existing and new investors happy, the company must decide how many new shares to issue and the estimated IPO price they plan to sell each share. The company’s executives and their investment bank determine the number of new shares by deciding how much money they hope to raise and how much ownership they are willing to give up.
Institutional Investors in IPO Process
Once executives and bankers decide on the number of new shares to issue, they reach out to institutional investors to start asking them how many shares they are interested in buying. Institutional investors include hedge funds, mutual funds, high net worth individuals, and pension funds in good standing with the investment bank.
Days before the IPO, the institutional investors place requests for how many shares they actually want to purchase. The company and its investment bankers then set the price for the IPO, and they know how much money they will raise.
The underwriting investment bank goes through the complex process of selling and allocating all the newly public shares to the institutional investors. They want to create a balance of different types of investors.
Retail Investors in IPO Process
Unfortunately for the at-home retail investor, it can be difficult to buy a stock at its IPO price. However, some brokerage platforms, like SoFi, have started to offer IPO Investing services that allow individuals to buy closer to the IPO price.
Determining Opening Price Point
Before the first day of trading, the stock exchanges on which the company decides to list look at all the incoming orders for the newly issued stock, which may be either buy or sell orders, and report the predominant price.
They then go through a process of price discovery to determine what the opening price will be. The goal is to have the maximum number of trades be executed from all the placed orders. At Nasdaq, this is done electronically, while human traders are involved at the NYSE.
Following this price discovery period, the opening price point is set, and the trading day continues. The stock is open for public trading.
Post-IPO Trading
In an ideal situation for the company and the underwriters, the stock’s closing price is relatively close to the opening price on opening day. This means the shares were priced accurately for what investors are willing to pay and the company had an appropriate valuation.
However, the IPO price isn’t necessarily a good indicator of the value of a stock. Broader market interest in the stock is impossible to plan for, and IPO conditions differ from the company’s long-term presence in the market.
IPO Price vs Opening Price: Similarities & Differences
Many analysts use the terms IPO price and opening price interchangeably when discussing a newly public company. However, there is a distinction between the two price points.
The IPO price is the price at which a company’s shares are first offered to institutional and accredited investors. The underwriters of the IPO sell the newly issued public share to these investors and clients at the initial public offering price.
In contrast, the opening price is the price at which the stock trades when it first begins trading on the stock market. The two prices are usually very close, but the opening price may be higher or lower than the IPO price.
Do IPO Stocks Always Rise?
IPO stocks don’t always rise in price once they are available for public trading. Highly talked about IPOs have disappointed in their opening weeks in the markets. This may be because investors feel these companies are overvalued and don’t want to risk putting money into them when they haven’t yet shown a profit.
It can take time for a stock to increase following an IPO, so the initial sale isn’t necessarily an indicator of long-term success or failure. The sale frenzy doesn’t always result in an immediate rise, but the influx of new capital allows the company to grow.
Many stocks experienced tumultuous action for months before seeing a steadier climb. As an investor, looking for companies with a solid team and business plan, rather than just hype and a high valuation, can result in long-term portfolio growth.
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How to Invest in IPOs
You can also expose yourself to a broad portfolio of new IPO stocks through an exchange-traded fund (ETF). ETFs offer a weighted balance of newly public stocks and are adjusted over time. By diversifying your portfolio, you benefit from any standout successes while avoiding huge losses.
Also, some online brokerages, like SoFi, offer IPO investing for retail investors.
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But, as mentioned above, IPOs can be very volatile. Although there is potential for significant returns, investors can also see severe losses in the weeks and months after a company goes public.
Rather than investing immediately, you can wait a quarter or six months to see how a company’s stock fluctuates following the IPO and then decide whether to invest. Stocks can often fall to form a base price before beginning to rise again.
The Takeaway
IPOs are all over the news for a reason: it’s exciting when a company opens up to public investment. However, it can be challenging for most investors to know when and how to add new IPO stocks to their portfolios. Ultimately, investing in newly public stocks can be risky; the decision should be based on financial goals, time horizon, and risk tolerance.
With a SoFi Invest® investment account, individuals have the tools to build a portfolio that’s right for them based on wealth-building goals. Investors can set up an Active Investing account to trade stocks, ETFs, or fractional shares with no commissions.
FAQ
Is it good to buy at IPO price?
Like all investments, there is risk in buying a stock when it goes public. IPOs can be suitable investments if the stock price increases after the IPO, but there is also a risk that the stock price could decrease. When buying a stock at an IPO price, investors don’t have the benefit of history to help analyze the stock.
How is an IPO price determined?
The IPO price is the initial public offering price of a stock. The IPO price is the price the underwriters will sell stock to institutional and accredited investors. The investment bank that works with the company going public determines the IPO price.
Can you lose money on an IPO?
An investor can lose money on an IPO if the company’s stock price falls below the price at which the investor bought the shares.
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Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.
New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.
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