What is an IPO and how does a company go public?

An initial public offering, or IPO, is the first time a company sells its shares to the general public and lists them on a stock exchange. Before it, the company is private, owned by founders, employees and early investors. After it, anyone with a brokerage account can trade the shares. For the company, an IPO is a way to raise money and gain a public currency; for investors, it is a chance to own a young public company, with some distinctive risks.

Why companies go public

• Raising capital. New shares sold in the offering bring cash for growth, acquisitions or paying down debt.
• Liquidity for owners. Founders, employees and early backers can eventually sell shares in an open market, instead of waiting for a private buyer.
• A currency for deals. Public shares can be used to pay for acquisitions or to compensate employees.
• Visibility and credibility. Being listed raises a company's profile.

The trade-offs are real: public companies must disclose detailed financial information, face scrutiny from analysts and shareholders, and accept regular reporting duties and compliance costs.

The main steps

1. Choosing underwriters. The company hires investment banks, called underwriters, to manage the offering, advise on timing and find buyers.
2. Filing with the SEC. The company files a registration statement, usually on Form S-1, with the Securities and Exchange Commission. It includes a prospectus describing the business, risks, financial statements, use of proceeds and ownership. Regulators review it, but their review is about disclosure, not an endorsement of the investment.
3. The roadshow. Management presents to large institutional investors to gauge demand.
4. Pricing. Just before trading begins, the company and underwriters set the offer price based on demand. Investors who receive allocations buy at that price. Allocations typically go mostly to institutions, and ordinary investors often cannot buy at the offer price.
5. First trade. The shares begin trading on an exchange (see NYSE vs Nasdaq). From then on, the price is set by supply and demand in the secondary market.

Underwriters earn a fee, usually a percentage of the money raised.

Example (illustrative numbers)

A company prices its IPO at $20 per share and sells 10 million new shares.

Gross proceeds = 10 million x $20 = $200 million

After underwriting fees and expenses, the company receives somewhat less. Suppose the shares open at $26 on the first day. Investors who were allocated shares at $20 have a 30% paper gain, while someone buying on the open pays $26. If the shares then drift down to $18 over the following months, the buyer at $26 has lost about 31%, and even the allocated investor is below the offer price. First-day gains are common in some periods but are not guaranteed, and many IPO stocks have traded below their offer price later.

Lock-ups and the quiet period

• Lock-up period. Insiders and early investors typically agree not to sell for a set time after the IPO, often around 180 days though the terms vary. When a lock-up ends, a large number of shares may become available to sell, which can pressure the price.
• Quiet period. Around the offering, the company and its underwriters face limits on promotional statements, so the prospectus is the main source of information. Research from the underwriting banks usually starts only after a waiting period.

Other routes to the public market

• Direct listing. The company lists existing shares on an exchange without issuing new ones or using the standard underwriting process. It does not raise money for the company in the same way.
• SPAC merger. A company merges with a publicly traded shell, a special purpose acquisition company. This route has different disclosure and incentive features from a standard IPO, and investors should read the merger documents carefully.

How to think about IPOs

Rules of thumb: a young company going public often has a short history of financial results, so there is less data to judge. Sellers choose when to go public and often do so when market conditions are favorable, so offer prices can look high relative to later results. That is a risk, not a rule. Read the prospectus, especially the risk factors, the use of proceeds, the ownership structure and whether voting control sits with a few holders (see dual-class shares).

Common mistakes and limits

• Chasing the first-day pop. Buying after a big jump means paying a price already set by the excitement.
• Treating hype as research. Media attention is not analysis of earnings, cash flow and competition.
• Ignoring dilution and lock-up expiry. Future share issuance and insider selling can weigh on the price.
• Assuming an IPO is a stamp of quality. Listing means a company met the rules to be listed, nothing more.

Where to see it on StocksXray

Once a company is public and part of the S&P 500 universe, its stock page, for example Apple's, links to its SEC filings, such as the annual report. See how to read a 10-K for what those documents contain.

Key takeaways

• An IPO is a private company's first sale of shares to the public, managed by underwriters and registered with the SEC.
• The offer price is set by demand; the market price afterward can be far above or below it.
• Lock-ups and limited operating history are specific risks to weigh.
• Direct listings and SPAC mergers are alternative routes to a public listing.
• Read the prospectus, particularly the risk factors, before forming a view.

This article is educational and is not investment advice.