- An initial public offering (IPO) marks a private company’s debut on a stock exchange and its issuance of publicly traded stock.
- Companies do IPOs for the prestige of going public and the cash the new shares bring.
- IPOs are often high risk, as the new shares’ prices can initially soar and then drop dramatically.
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An “IPO,” short for initial public offering, is a big day in the life of a business. It’s the point at which a privately owned business makes it to the major leagues of the publicly traded companies â€” and onto stock exchanges like the NYSE or the NASDAQ.
It’s also a chance for early investors to make a killing â€” like in September 2020, when software company Snowflake‘s price more than doubled on its opening day, breaking records as the largest-ever US software initial public offering.
So it’s no surprise that pumped-up investors jump on IPOs. In 2019, 235 companies went public for a total of $US65.4 billion, according to FactSet. The analytics firm also notes that 283 companies had IPOs in the first three quarters of 2020.
IPOs offer a chance to get in on the ground floor of a newly launched stock. Here are the risks and rewards â€” the ABCs of IPOs â€” that investors need to know.
How the IPO process works
An IPO means that a company is transitioning from private ownership to public ownership. To wit, the process is often referred to as “going public.” Going public is the dream of many a company. But a successful IPO is rooted in a “viable business model that will interest investors,” says Previn Waas, a partner at Deloitte & Touche and the leader of its IPO Centre of Excellence.
When they’re ready to pull the trigger, owners and initial backers of a private business will “consult with banks to underwrite the deal. Next, the banks will present their view of the company.”
A lot of thinking goes into the timing, including whether the current market is receptive to initial public offerings in general and that company in particular.
If it looks like a go, the company and its backers will select a banking syndicate â€” a group of institutions that share the going-public costs â€” to lead the IPO, Waas adds. With their help, “the company will draft an S-1 registration,” or prospectus, which can take two or three months.
The S-1 is required as a way to disclose to potential investors about the company’s business, financial statements, potential risks, and its plans for how the cash raised from the public offering will be used. “The SEC will review the S-1 and may send it back with questions or comments,” says Waas, adding that it could go through multiple drafts until it’s accepted.”
Building the book
After the SEC gives its blessing, the new company and its backers have to price the public offering. Too low could mean missing out on a lot of capital, but pricing that’s too high could choke off demand.
That’s where “book building” comes in â€” performed by an underwriter, or investment bank, in collaboration with the IPO’s backers, notes Jay R. Ritter, the Joseph B. Cordell Eminent Scholar Chair at the University of Florida’s Warrington College of Business. “The underwriter gets information about the state of demand from institutional investors, and then recommends an offer price.”
A date is set to go public. The day before, about 90% of shares are allocated â€” pre-sold, in a sense â€” to certain institutional investors, mainly hedge funds and mutual funds.
Finally, “the stock opens for trading on Nasdaq or the NYSE the next morning. A ‘designated market maker’ is assigned the task of opening trading at a price that balances supply and demand,” according to Ritter.
And they’re off. The stock starts trading. The share price can jump â€” as it did with Snowflake. Or it can fall, like ride-hailing pioneer Uber, which dropped more than 7% on its first trading day in 2019.
Why do companies go public?
- Raise capital: An IPO brings an immediate cash infusion from the stock sales for a company, its owners, and those who already owned a piece of it, like venture capitalists (who often cash out at this point). In 2020, “the average deal was $US186 million,” notes Joe Daniels, co-chair of law firm McCarter & English‘s Venture Capital & Emerging Growth Companies practice.
- Long-term benefits:“Stock that is listed on a major exchange may be more easily used for ‘acquisition currency,'” says Daniels â€” meaning a public company can make an all-stock, or cash-and-stock bid for another company it wants to buy, instead of making an all-cash offer than may require heavy borrowing. A publicly traded company can do a better job of attracting and retaining talent, since “stock and options are considered much more valuable incentive compensation,” he adds.
- Cachet: There’s prestige in going public. “A listed company may be perceived as more reliable to counterparties, lenders, and investors,” Daniels says.
The drawbacks of going public
Going public isn’t all roses. It “does add another layer of complexity to the business,” says Chris DeCresce, a partner in the law firm Covington whose practice focus includes securities and capital markets.
“Drafting the S-1 can put a lot of stress on the CFO and the accountants. It can also distract the management team from their traditional business responsibilities for months at a time.”
Even after a successful IPO, “there are multiple SEC filing requirements that include annual, quarterly and other detailed reports,” he adds. “Publicly held companies typically have to hire more people in their accounting and other departments, and pay more for employees who have regulatory experience.”
And a publicly held company can no longer operate in the shadows. The business’s financial results â€” and by extension its top management â€” will be scrutinised by regulators, shareholders, portfolio managers and reporters. Actions that used to be considered in a relatively straightforward way must now be weighed against their effect on short-term issues like quarterly earnings and stock prices.
Sometimes, even announcing an IPO can blow up a company. That’s what happened in 2019 when coworking company WeWork publicly filed its IPO paperwork. Investors and the media put WeWork’s finances and leadership under the microscope, and a series of red flags were soon raised. In September 2019, WeWork shelved its IPO.
And finally, while successful firms tend to be the ones that launch, there’s no guarantee the market will embrace them. According to the independent news and research firm IPOScoop, of nearly 200 IPOs tracked in 2020 through early December, 53 were down from their opening day price.
Still, IPO investments overall returned a nearly 65% yield year-to-date, according to IPOScoop, compared to nearly 38% for the NASDAQ Composite Index.
Investing in an IPO
So there’s certainly been opportunities to profit from IPOs, with a “39% average first-day pop [share-price increase],” according to a 2020 third-quarter report by Renaissance Capital, which provides pre-IPO institutional research, and management of IPO-focused investment products. Its Renaissance IPO Index gained 27% compared to the S&P 500’s 6%. But for average individual investors, it could be tough to get in on the action, says Kathleen Shelton Smith, a co-founder and principal of Renaissance Capital LLC.
First, there’s a question of being able to buy into an IPO â€” that aforementioned 90% allocation to the investment funds. “It’s often very difficult for a Main Street investor to get IPO shares,” she says. “Most of them go to large institutions and high-net-worth customers of big brokerages.”
Other challenges can include finding out about an IPO, although sometimes, a good-hearted broker will tip off their customers, even if they’re not big-wheel ones. Or investors can track down upcoming IPOs by checking out the NASDAQ IPO Calendar.
Some brokerages do reserve slots for small investors. E*Trade, for example, lets customers place a “conditional offer,” where an individual specifies the number of shares and the maximum price he or she is willing to pay. “However, submitting a conditional offer does not necessarily mean that you will be allocated shares; the allocation of shares depends on many factors,” according to E*Trade’s website.
Fidelity also gets access to some IPOs. Fidelity also allocates some of those IPO shares to its brokerage customers. But they need a “minimum of $US100,000 in certain assets at Fidelity,” according to the website. And that minimum only gets investors behind the gate for IPOs underwritten by Kohlberg Kravis Roberts & Co., one of Fidelity’s business partners. “Other providers of traditional IPOs, and other equity public offerings made through Fidelity may be reserved for brokerage customers with a minimum of $US100,000 or $US500,000 in certain assets at Fidelity.”
Some alternate ways to buy IPOs
- One way for small investors to get into an IPO is through a SPAC (Special Purpose Acquisition Company) It’s basically a new publicly traded firm with operations, no assets â€” other than a war chest of cash â€” and just one stated business plan: to eventually buy another company. The high number of shares sold in a SPAC offering makes it easier for smaller investors to get in early.
- Another way is to buy into a pool of recently minted IPOs. For example, Renaissance Capital’s U.S. and International IPO ETFs (exchange-traded funds) offer small investors a chance to diversify while getting into those newly issued securities. “Our ETFs â€” which are traded like stocks â€” represent a portfolio of recent IPOs,” explains Smith. “So an investor doesn’t face the risk associated with a single stock selection. The ETFs are also designed to emphasise larger companies that went IPO, which studies indicate are a slightly safer bet compared to small-company IPOs.”
The financial takeaway
There’s always a lot of excitement around a company that goes public. So when an IPO happens, investors can quickly bid prices up, offering early investors a quick way to make some good money. Or a quick way to lose some or all of their investment, if the shares nosedive â€” right away, or in the following months.
IPOs involve taking a chance on a company â€”one that has a good history and promising prospects but is an untried player in the public markets. They may favour it or deem it overvalued.
But individuals who carefully examine the S-1 registration and the company’s management teams may be able to improve their chances of landing a winning IPO.