A privately owned company transitions to a publicly traded company through an IPO
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What Is an Initial Public Offering (IPO)?
As a business evolves, a privately held company might decide to transition into a publicly owned entity. This transition can happen to a business at any stage of its life cycle, whether it’s a brand-new startup or a company that has been around for generations. The process it undertakes is known as the initial public offering (IPO), where shares of company stock become available for purchase by the public. That’s why a business that issues an IPO is known as “going public.”
Why Do Companies Go Public?
It all boils down to capital. Companies issue IPOs in order to grow and expand. Going public gives them access to a lot of money, which can be used to facilitate acquisitions, fund research projects, pay off debts, or undertake other financial endeavors. It also allows private shareholders, such as angel investors or the company’s founders, to create liquidity by monetizing their investments. IPOs provide a big boost to a company in terms of visibility, transparency, and even credibility to the public—and they could also help the company secure better terms from its lenders.
How Does an IPO Work?
There are two phases to the IPO process, which takes about a year to complete from start to finish.
1. Preparing to Go Public
The first phase is when the company begins advertising its intentions to the public. All companies considering IPOs should have sound financials and a track record of profitability.
Startups with $1 billion in assets are known as having unicorn status because finding one is as rare as uncovering the legendary beast. Examples of unicorn IPOs include Google, Airbnb, SpaceX, and Robinhood.
Companies that issue IPOs must also register with the Securities and Exchange Commission (SEC). The SEC approves the IPO by rendering its S-1 registration as “effective,” which should in no way be considered an endorsement of the company, nor does it guarantee future solvency. Investing in IPOs involves quite a few risks, which we’ll get into further below.
2. Going Public
The next phase of the IPO process involves an investment bank, which underwrites the contract to offer company shares to the public and performs due diligence to price shares fairly. It then sets the issue price, or offering price. This information is packaged into a prospectus, which is distributed to prospective shareholders. (The first draft of the prospectus is known as the red herring, because it has red warning letters printed along its side, letting everyone know the information has yet to be finalized.) The investment bank also lists the shares on the stock market and assembles a group of institutional investors, known as a syndicate, which facilitates the sale of IPO shares. The company then forms a board of directors, which pledges to provide financial updates on a quarterly basis.
Once these requirements are met and the SEC has rendered the IPO registration effective, the company’s stock can begin trading on a stock exchange, like the New York Stock Exchange or the Nasdaq. The process of going public is also known as floating.
The 10-day period after an IPO’s first trading day is known as the quiet period. During this timeframe, all parties involved are prohibited from issuing earnings forecasts or other analysis in order to limit insider trading.
While investors can technically sell their IPO shares within the first few days of trading, the practice is strongly discouraged because the whole point of a company going public is to generate long-term investment, not short-term volatility. In fact, there’s even a term for it: Flipping. Doing so could prevent an investor from participating in future public offerings.
What Are the 10 Biggest IPOs in History?
Some of the largest IPOs in history have occurred in the past few years. Here are a few:
How Can I Participate In an IPO?
Investors who are interested in investing in an IPO usually must have between $100,000 and $500,000 in household assets, which excludes 401k or annuity assets. And since investors can only participate through a brokerage firm, such as Charles Schwab, Fidelity, or TD Ameritrade, they must also be a client. Demand usually outpaces supply of IPO shares, and so most brokerages use a formula to determine eligibility made up of factors like assets, trading activity, and other customer history.
To express interest in the IPO, investors usually need to have at least $2,000 in their specified account. The minimum investment is typically 100 shares. An email to investors is sent on the morning of the effective date with the expected pricing, and investors must confirm the transaction.
How Can I Get the Offer Price?
Even if an investor is eligible to participate in an IPO through their brokerage, they might not be able to get the IPO at its offer price because brokerages only get a certain number of shares once the company goes public. It’s usually the institutional or accredited investors who have the first opportunity for IPO shares; however, trading platforms like Robinhood enable individual investors to have access to certain IPOs.
Are IPOs a Good Investment?
There’s certainly a lot of hype surrounding IPOs—who wouldn’t want to be an early-in investor on the next Tesla or Google?
However, there are just as many risks to investing in IPOs as there are advantages, simply because there isn’t a lot of data available yet about the company, as its very viability has yet to be determined. Many IPOs have made a big splash on Wall Street only to go bankrupt after posting dismal earnings just a few years down the road; this happened frequently during the dotcom bubble of the late 1990s.
Thinking of investing in an IPO the day it goes public? There are risks here as well, as early initial trading could overinflate prices, causing investors to pay more than the stock is worth. In addition, the first trading day of an IPO typically sees a lot of volatility, which could extend for a longer period, as well.
As always, it pays for an investor to do their homework and carefully research any company they are considering investing in—especially IPOs. One way to mitigate risk might be to consider an ETF that invests in IPOs, for a more balanced approach.
