What Is An IPO? How Do They Work?

IPO stands for initial public offering, and is sometimes referred to as a public offering. It occurs when a private company becomes a public company by offering shares of the company to anyone interested in buying the stock, rather than just private investors.

The money paid for the stock at the IPO becomes capital the company can use as it sees fit, including for operating costs, investments, or to pay down debt. 

IPOs are one of the ways that businesses can raise capital. However, before we get into the ins and outs of IPOs, we should probably go over the other ways that businesses can get funding. 

Taking on debt is one option. This means that the company is borrowing money in the form of a bank loan, or just issuing the debt to itself. The debt has to be repaid over a period of time in installments, plus interest, of course. 

Another option is to issue equity to investors. This means that you are offering ownership of part of your company in exchange for money. The advantage is that you don’t have to pay this money back, however you do have to share partial ownership of your company. This is what many early stage companies tend to do as it is much more private and they don’t have to disclose sensitive information to the public. 

Finally, there’s the option to IPO, or offer shares of your company to the public to be traded on an exchange. This is quite a long and complex process that often takes quite a few months to complete.

The company going public chooses an underwriting firm or an investment bank, such as JPMorgan, Goldman Sachs, or Morgan Stanley to perform the IPO. They will help decide who is responsible for determining the number of shares and how much each share will be sold for. The underwriter also helps determine the timeline of the process and the best types of securities to offer.

These decisions are made by shopping the opportunity around to their network of investors, who indicate their level of interest and the price they are willing to pay for owning shares of the company. These investors may also make guarantees that they will buy a certain amount of shares at certain prices or hold the stock for a certain amount of time after the public offering.

The company going public pays the underwriter or investment bank a fee for their services, typically from 2% to 8% of the value of the stock. This fee is paid to the underwriter when shares of the company are sold, by pricing in a spread called the underwriter’s spread.

Once the IPO takes place, the general public is able to purchase the stock starting at the determined price, but as it trades on an exchange, the price is allowed to rise and fall as any other stock price would.

If a company prefers to go public without incurring the fees for an IPO service, a “direct listing” with a stock exchange is another way to go public.

A direct listing is a less centralized, more democratic process. This is because existing private investors, including employees and owners, can sell their shares directly. It does not raise fresh funds for the company, but rather it is a way for existing investors to monetize their shares.

Direct listing also does not get the same institutional assurances and guarantees of an IPO but the lower costs and the open process often makes it a preferred alternative for smaller companies and startups. Two notable companies that have gone through with direct listings are Slack and Spotify. Though both companies succeeded in their market debuts, their share prices have struggled since then. 

Vice Chairman and Chief Commercial Officer of NYSE, John Tuttle, said the following about direct listing, “Will this displace the traditional IPO? No, but is it another pathway we are providing companies to come to the public markets and to have investors participate and (have) growth opportunities? Yes.”

Raising a larger amount of capital for growth is the primary benefit of becoming a public company. However, once shares are offered on the open market, corporate records, management, and policies are openly scrutinized. Also, public shareholders can make changes to the operation of the business, taking power away from the original founders, owners, and managers of the company, possibly even replacing them.

Before becoming a public company, the owners of a private company search for capital from private investors and decide which investors they want to work with and how those investors might benefit. This allows closely held companies to make independent decisions about company operations, investments, personnel, and the amount of influence private investors have on decision making. However, the limited number of investors also holds down the amount of capital available to the company, which can also curtail its growth potential.

The year 2020 was one of the best years in recent history for the IPO market, and 2021 proved to be even better. Nearly $600B dollars was raised globally in IPOs, easily passing records. The U.S. passed the previous record set for IPOs in the 1990s, with almost 1,000 companies coming to the market raising $315 billion.

Special purpose acquisition companies, or SPACs as they are commonly referred to, played an important role in this development by helping many young companies go public.

SPACs, also known as blank check companies, have no commercial operations and stated targets and are formed solely for the purpose of raising capital through an initial public offering to invest in another company later. These companies are capable of facilitating private companies to go public faster while allowing public investors access to markets previously only available to accredited investors, and SPACs have become increasingly popular in recent years. In 2021, SPACs raised nearly $160B. 

That volume has slowed down in 2022 as the market has fallen. According to Ernst & Young, IPO volume fell 46% in the first half of 2022 while proceeds raised fell 58%. A common reaction to a bear market environment, the fall in the volume of IPOs and new SPACs may also have to do with the poor performance of recent IPOs, as many high-flying stocks have sold off. The Renaissance IPO ETF, which tracks newly IPO’d companies, has dropped 44% in the first 7 months of 2022, and over 50% since November 2021.

No matter how much newly public companies are hyped, they can carry risk as they find their place in the market. Investors should keep a cautious outlook and remember the potential downsides of investing in IPOs. It can be difficult to calculate the value of recently private companies that have no trading history or public quarterly financial results.

According to the findings of Jay Ritter, identifying a good IPO investment comes down to sales growth and the absolute value of annual revenue at the time of a company’s market debut. Empirical evidence suggests investors should always choose the company with the highest reported revenue if they were given a choice to invest in a group of IPO companies with varying levels of revenue.

In any case, investors should prepare to stomach some volatility if they are planning to reap the rewards of investing in a young and fast-growing company. Even in 2021, the stock prices of some of the high-flying market debutants such as Coinbase and Robinhood plummeted, highlighting the importance of picking the right IPO to invest in.

An example of smart decision making regarding investing in IPOs can be learned from billionaire entrepreneur, Mark Cuban. Most famously known for his role on Shark Tank, Mark Cuban is also involved in countless other projects and has become one of the most sought after investors. 

When asked on CNBC if he would have bought the Uber IPO, he responded 

“No exact opposite, that’s one I would not have bought. I think if you’ve been in business 10-11 years and you still have not gone public and you’re not in that hyper growth phase anymore it’s probably too late. I think companies need to go public much earlier, you need to be in that hyper growth phase cause that’s what distinguishes you from all the other stocks in the market. There’s plenty of mature stocks, there’s plenty of growth stocks but there aren’t a lot of stocks that are experiencing hypergrowth and being able to take advantage of the liquidity that it provides not just the company itself but all your employees and your early investors I think really makes a huge difference for companies.”

The IPO calendar on Investing.com is a very useful tool if you’re looking to stay updated on IPOs. It lists upcoming initial public offerings in a table with sortable columns. The columns include the company name, the exchange it will be listed on, the IPO value, and the expected price per share.

The table can also be filtered for recent IPOs by clicking the button at the upper left corner of the table. The table of recent IPOs can also be sorted by columns. The links to each company take the user to pages with company details, data, charts, news, and information.

Picking the right IPO to invest in is crucial, which is where Investing Pro comes in. Investing Pro offers exclusive data and insights about IPO companies using in-depth company analysis tools. You’ll get access to the most comprehensive company data ever, including up to 10 years’ worth of financial reports so you can make informed investment decisions. Data metrics like company health scores, cash flow statements and valuation models will all help to make sure you always pick the leader.