Initial public offering, also known as an IPO is when a privately owned company goes public. ‘Going public‘ means the company now has shares on the stock exchange that can be bought by the public. This is a big deal and can put a company in a position to scale up and experience exponential growth. When people buy shares or invest in the company, the organization has more capital to put towards growth.
IPOs can be like a shiny new object for investors as a company new to the stock exchange has potential of being a lucrative investment opportunity. Mega businesses that are now profitable like Tesla and Amazon were once private companies that went public by announcing IPOs.
How Does an IPO Work
The first step a company takes when becoming an initial public offering is fulfilling public reporting requirements by registering with the Securities and Exchange Commission (SEC). The Securities Act has made it a prerequisite for companies to do this before they can sell shares, with an exception of a few. Once you’ve submitted a registration statement, companies must wait for the SEC to mark their registration statement “effective” before they can start selling shares.
After registration business is done, it’s time to go through an underwriter syndicate to get investors to buy shares. During this process, a lead underwriter, investment banks and broker dealers come together to sell the company’s shares to investors.
It’s also important to know that companies who undergo an IPO must start filing reports thanks to the Exchange Act reporting requirements. Annual reports are filed on form 10-K and quarterly reports are filed on form10-Q. Examples of information required in the reports include a company’s financial health, operating results, and management compensation.
Pros And Cons Of An IPO
The biggest benefit of going public with an IPO is that a company can raise more capital to funnel into their business. Other benefits include a company gaining more visibility and the ability to offer existing and prospective employees shares in the company. Giving employees shares in the company can motivate them to bring their best to work everyday because when the business does well, their shares are likely to appreciate in value.
The downside of going public is it requires a great deal of heavy lifting to register the IPO as there can be tedious amounts of paperwork. Additionally, after the company is registered, they must keep up with the SEC reporting requirements, which can be time-consuming. Also, reports can put pressure on companies to perform within each reporting period, especially because the findings from each report can affect demand for company shares.
Other cons include:
- Increased scrutiny from the public
- Stakeholders having less ownership of the company
- The value of the shares being affected by market changes
Investing In IPOs
Some IPOs come with hype and it can make investors feel pressured to hop on board. Just because there’s buzz about a company going public, it doesn’t mean they’re going to perform well long-term. An example is EToys, a company that attempted to compete with Toys R Us in 1999. Their shares were priced at $20 when they went public but were traded as high as $75 per share. However, by 2001 the company went bankrupt.
Conversely, there are many success stories meaning some companies have gone public and continued to experience growth in their stock price. For investors who bought shares in said companies as soon as they went public, they saw positive returns on their investments.
Investors should always do research before putting money into an asset. This can be tricky when it comes to IPOs because they haven’t been public for long and don’t have much information for investors to vet. All hope isn’t lost-newly public companies usually have a red herring, which is a prospectus that gives you detailed information about a company. That includes data like who is on their management team, target market, financials, competitive landscape, current share owners, expected price range, potential risks, and the number of shares that will be issued.
There is also the option of participating in an IPO, which gives investors first dibs on shares. They agree to buy shares at the offering price before the shares get traded on the secondary market–where investors buy and sell securities. Certain requirements have to be met before you can participate in an IPO like being a seasoned trader, high-networth individual, or having a long-term relationship with a brokerage.
If you’re interested in participating in an IPO or buying shares of a company that just went public, NASDAQ has an IPO calendar that you can use to scout for potential companies. You may also speak to one of our financial planners if you need help navigating the process.
