Definition: An initial public offering (IPO) is a process by which a private company makes its shares available to the general public for the first time. It involves the sale of stock in the company to investors, who can then buy and trade the shares on public stock exchanges.
Understanding IPOs
The IPO process typically involves several steps, including selecting underwriters, preparing financial statements, filing regulatory documents, and marketing the offering to potential investors. The main purpose of an IPO is to raise capital for the company’s growth and expansion, while also providing an opportunity for early investors and employees to sell their shares and realize profits.
The media hype surrounding the event may make it tempting to buy stock in companies that have recently gone public, but investing in an IPO can be like jumping into deep water – it may not be suitable for new investors looking for a stable or predictable investment. For more information on investing in IPOs, see the Securities and Exchange Commission’s Investor Bulletin.
Why are companies going public?
For many companies, an initial public offering (IPO) is a way to raise significant amounts of new capital to grow the business. “In addition, an IPO increases the liquidity of a company’s stock, making it easier to convert it into cash. Finally, going public can encourage better management practices that can benefit shareholders because of the stringent financial reporting requirements of going public.
IPO stock pricing and listing
Typically, companies hire one or more investment banks to advise on stock pricing. This is followed by a preliminary prospectus and S-1, which details the business model and plans to raise capital. This is followed by a roadshow with institutional shareholders, analysts, hedge funds and fund managers. The company and its bankers then determine the share price.
The company issues new shares for listing on the stock exchange at the initial share price. The company receives money from investors who buy shares in exchange for its stock.After the offering, the shares are freely traded on the secondary market, and most investors (except for some company insiders with limited rights) can buy and sell shares as they see fit.
What happens on IPO day?
Investing in any stock involves the risk that the stock price may rise or fall, and this is especially true on listing day. The stock then trades on the open market, initially at the final IPO price and then on a free float basis in response to investor demand.
At 9:30 a.m. Eastern Time (when the market opens), the stock begins trading in the United States. However, bidding on the day of the initial public offering (IPO) usually does not begin until some time later, due to pent-up demand and a limited supply of shares. Once trading begins, investors can buy and sell shares of the new company through their brokerage firm.
Are there any risks in trading newly listed shares?
Risks exist in trading all stocks, especially the stock of newly listed companies. Hype can be a source of volatility: IPOs are often the subject of intense media attention, and statements from management or underwriters may reflect too much or not enough optimism in the early days of trading. This heightened attention can lead to increased volatility, i.e., a significant rise or fall in prices in a single day.
Investment banks can protect the stock price:
Bank underwriters can protect the stock price from falling too much in the days following an IPO. What’s more, they can even buy stock in a company that has just gone public. Once that support stops, the share price can fall below the offer price. Check the company’s IPO registration documents for this type of price support.However, IPOs are considered speculative, and an investor should read the IPO prospectus carefully.
A prospectus is a required document filed by an IPO company and is usually published a few weeks before the IPO. It is designed to provide investors with information to help them decide whether the issue is a suitable investment, such as terms and conditions, information about the company’s financial position, the risks it faces, and details about its business model.
Direct listing: An alternative way to go public
Both an initial public offering (IPO) and a direct listing give individual investors the opportunity to invest in companies for the first time, but there are a few key differences. Unlike an IPO, a direct listing does not involve issuing new shares or raising new capital. As a result, there is no need for investor roadshows, and the fees paid to investment banks by the issuing company are lower.
Companies with strong brands that do not need to raise new capital are typically attracted to a direct listing: their primary need is to be able to publicly offer their shares so that early investors and shareholders can sell their shares – a direct listing can meet this need, and potentially more effectively. Spotify’s 2018 direct listing is a well-known example.