What is an IPO and Why Do Companies Go Public?

How Does an IPO Work?

An IPO is a sophisticated process that requires underwriters, typically large banks, to conduct an examination of the company’s financials and operations to establish an appropriate share price, which is used upon its listing on a public exchange where those shares can then be bought and sold by market participants. The underwriters also ensure compliance with regulatory and legal requirements. Stakeholders take their company public with the aim of the share price increasing, which helps fund equity capital needs for the company to finance operations or pay debt, although this doesn’t always occur.

Why Do Companies Go Public?

There are several reasons why companies decide to go public. The first is that an IPO provides a substantial ability to raise capital going beyond what private investors can typically provide. An IPO also enhances a company’s public profile, boosting brand awareness and market credibility. This visibility often translates into a competitive advantage for a company.

It also increases liquidity, allowing early investors the chance to sell their shares and make a return on their initial investment in the company. An IPO also can come with several potential disadvantages. There is more scrutiny on a company that is public, as regulatory and legal oversights increase to protect the public, which is made up of ordinary investors who lack the sophistication of private investors who are more financially savvy. It also requires the company to file quarterly and annual reports with regulatory authorities who require more transparency to protect the public.

Reasons why companies opt for IPOs:

• Equity funding: Companies can leverage capital raised by the IPO to fund projects, enter new markets, or boost operations
• Public recognition: Becoming a public entity elevates the company’s profile and status, attracting new customers and business opportunities
• Liquidity for investors: Provides early investors the freedom to sell their shares and monetize their initial investments
• Employee incentives: Stock options can be used to attract and retain talent by offering vested interests
• Debt management and flexibility: Improved financial metrics can lead to more favorable borrowing terms in addition to paying off existing debt with the funds from the IPO

IPO Process

Once leadership is confident that their company is mature enough to trade on a public market, they will begin the process for an initial public offering. This includes preliminary consultations with investment banks, who may go on to serve as underwriters. These underwriters help to determine the amount of capital to be raised, the initial share price range and other financial specifics that are required for the filing.

The proposed IPO then goes into a regulatory approval process. An authority such as the Securities and Exchange Commission (SEC) reviews the filing to ensure that it complies with applicable laws and regulations. In the United States, the S-1 is the official filing that kicks off the regulatory process. The time to listing from the S-1 filing is typically a couple of months to a year.

Often, the company will gauge interest from potential institutional investors by going on a roadshow. A roadshow is where the company presents its IPO to potential investors to gauge how much interest the IPO will attract. It also helps to fine-tune the share price range for the IPO. At this point, some IPOs will fall through, and management will decide to stay private or do the IPO later in time.

If the roadshow is successful, the company will move forward with its listing. A scheduled date for the IPO will be set and marketed to potential investors. The schedule date is when the company will list on a public exchange and its stock will begin trading. At some point before the listing, the company is required to establish a board of directors. This board is responsible for legal governance, ensuring oversight and protecting shareholder interests. The listing raises capital for the company, which is commonly used to invest in future growth while also allowing early investors to cash in on their investment.

IPO Steps

• Proposals: Underwriters advise on valuations such as the proposed share price range for the offering and the timeline for the IPO
• Underwriter selection: Companies decide what underwriter to use to lead the IPO to market and decide on terms through a formal agreement
• Team formation: A team of experts is formed, comprising lawyers, accountants, and regulatory advisors specializing in SEC regulations
• Documentation: The company compiles exhaustive documentation and files its S-1 Registration Statement, which serves as the primary filing with the SEC
• Marketing & updates: A comprehensive marketing strategy, or roadshow, kicks off spearheaded by underwriters and company executives to gauge investor appetite and the final listing price range
• Board & processes: Establishing a board of directors is required to properly govern the company, ensure regulatory and legal compliance, and protect shareholder interests
• Shares issued: Shares start trading on an exchange at a certain date, which is predetermined earlier in the process
• Post-IPO provisions: Includes provisions for additional share offerings and adherence to any stipulated lockout periods for early investors

Trading an IPO

Before shares start trading on an exchange, which represents the secondary market, companies often hold several shares for a group of accredited and institutional investors that include venture capital firms and high-net-worth individuals. Recently, select brokers have allowed regular individual investors to obtain shares before they start trading on an exchange.

While IPO access can be relatively uncommon for regular investors, it provides the potential benefit of profiting early on an IPO if the company’s stock price rises after it starts trading in the secondary market. However, IPO investing comes with risks as well. The primary risk is from uncertainty around liquidity and volatility since IPO shares are not publicly tradable yet. Often, traders who purchase IPO shares need to wait until the stock starts trading on the market before they can sell their shares and may even be subjected to a lock up period where you are restricted from selling as insiders, employees, or early investors for a certain period. Another risk is that brokers who offer IPO shares to regular investors typically only allow limit orders, meaning that a fill price for an order is not guaranteed.

Once a company is listed on the exchange, it begins trading in the secondary market. We will refer to this as post-IPO for simplicity. This means that it behaves like any other stock. A trader can simply enter the ticker symbol in their platform and place a buy or sell order as they would with any other publicly traded stock. The benefit of trading a newly listed stock once it is trading on the secondary market is that it offers greater liquidity—meaning that it is easier to get in and out of the position.

Benefits and Risks of IPO and Post-IPO Trading

IPO Terms to Know

Being familiar with IPO terminology is important for investors and stakeholders to navigate this complex process.

• Common Stock: Represents the units of ownership in a corporation, which can provide voting rights and dividends.
• Issue Price: The price at which shares will initially start trading at the time of listing.
• Preliminary Prospectus: A formal document outlining essential information about the issuing company’s business, financials, and strategy. In the United States, this is the S-1 form.
• Underwriter: The financial institution or consortium, often large banks, tasked with facilitating the IPO process, which includes consulting with company leadership and providing legal and regulatory guidance.

SPACs vs. IPOs: What Are the Differences?

SPACs are Special Purpose Acquisition Companies. SPACs are essentially shell companies that raise capital via an IPO with the intent of acquiring an existing company. The targeted company then can merge with the SPAC to list on public markets, sidestepping the IPO process.

SPACs allow for an accelerated timeline to take a company public and are often cheaper than an IPO. However, merging a SPAC with a company can sometimes involve complex and specific requirements regarding financial reporting. Once management conveys its intent to go public via a SPAC, it only has a few months to complete the process.