What Is an Initial Public Offering (IPO)?
An initial public offering (IPO) refers to the first sale of stock issued by a private company to the general public. IPOs grant the general public the ability to buy shares and own a portion of a company — often for the first time. Colloquially, when a company has an IPO, it’s said the company is “going public.”
IPOs have numerous pros and cons for companies and investors alike. In this overview, we will introduce the basics of IPOs.
How Do Companies Begin the IPO Process?
When a private company goes public, it undergoes the IPO process. A private company must first register its IPO with the US Securities and Exchange Commission (SEC). Domestic companies going public normally file a Form S-1 with the SEC. International companies wanting to list on a US exchange will file a Form F-1. The S-1 is a must-read for anyone interested in investing in an IPO because it includes key details such as a company’s industry, its recent financials, team composition, and more.
As a company prepares to go public, it normally hires lawyers and underwriters to help with the IPO process. Underwriters are financial institutions (typically investment banks) that buy shares of the company before distributing shares to the general public. Companies also choose lead underwriters to help guide the IPO process and allocate shares to others. Underwriters help the company determine an offering price, the number of shares being offered, and more.
Companies also apply to list their shares on one of several stock exchanges, with the most common and well-known exchanges being the New York Stock Exchange and the Nasdaq Stock Market.
Why Do Companies Go Public?
IPOs require a great deal of resources, time, and attention. So why would a company decide to go public?
The most common reason companies go public is to raise capital. Prior to going public, most startups primarily fund themselves via venture capitalists, angel investors, crowdfunding, and so on. Founders exchange ownership, or equity, in their companies for funding in order to start or expand their budding companies. As a company matures, it may no longer be able to fund itself through private means. Raising funds from the general public through an IPO can grant companies an enormous amount of funding.
Exit Opportunities for Early Investors
IPOs aren’t just beneficial to companies – they’re also beneficial to the VCs, angel investors, and other early investors that funded the early days of a startup. While companies are private, these stakeholders don’t have many options for trading or selling their shares. Startup equity is notoriously difficult to sell (though secondary markets are beginning to offer new options for liquidity). As such, IPOs are the primary means by which early stakeholders – including founders, early employees, and investors – can cash out their equity.
IPOs can provide an immense amount of publicity for companies. Investment bank roadshows (marketing presentations and pitches) and other public-facing events can bring more awareness to companies that are going public, leading to more investors and customers. While not as important as raising additional capital and helping existing shareholders exit, more publicity for under-the-radar companies can be a good thing.
Alternative Ways to Go Public
The traditional IPO process is time consuming and expensive. For companies that want an easier route to share liquidity and capital opportunities, there are other ways to go public.
In a direct listing, or direct public offering, private companies can skip the process of hiring an investment bank as an underwriter. While underwriters can still help, their role tends to be diminished. Companies pursuing a direct listing instead rely on an auction system by the stock exchange to set the IPO price. Coinbase’s direct listing is a prominent example.
Special Purpose Acquisition Companies (SPACs)
Special purpose acquisition companies (SPACs), or blank check companies, have become an increasingly popular method to go public. A SPAC is a publicly traded shell company with no real commercial operations. It is formed solely to raise capital via an IPO for the purpose of acquiring or merging with a private company, thereby taking the private company public. Since SPACs have no real operations or financials, SEC clearance is much faster, taking only around one to three months. Traditional IPOs can take half a year or longer to prepare.
SPACs raise capital from the general public without the public knowing the target acquisition or merger. Because of the vague nature of the acquisition targets and little regulatory oversight, SPACs can be incredibly risky investments. Examples of well-known companies using SPACs to go public include DraftKings and Opendoor.
Are IPOs Good Investment Opportunities?
As the final stage of a startup or company’s lifecycle, IPOs present an opportunity to own shares of previously private companies. An IPO, however, can be a risky investment because the company’s valuation and offering price have yet to be determined by the market forces of supply and demand. Instead, these metrics have been determined by the company and its underwriters.
Additionally, purchasing shares at the offering price or shortly after a company has gone public can be risky. The market forces of supply and demand ultimately determine how fair a company’s price is after it goes public. IPO lock-up periods can also affect share prices after an IPO. As such, investors who want to avoid high-risk investments may be better off waiting a while before investing in a newly public company.
How Can Someone Invest in an IPO?
The average investor normally doesn’t have access to the shares offered in an IPO. Traditionally, IPO investing was limited to those with access to the investment bank acting as the IPO’s underwriter.
If an investor is a client of an underwriter involved in the IPO, the investor may have an opportunity to participate in the IPO by purchasing shares at the offering price. But, underwriters will usually reserve and distribute IPO shares to institutional investors, including mutual funds, hedge funds, and high net-worth individuals. As such, the average investor is rarely able to invest at the best possible price until after the IPO.
However, innovative and tech-forward financial institutions, including SoFi and Robinhood, are democratizing IPO investing. The two financial institutions have set out to make IPO investing possible for the average investor.
IPO Overview Conclusion
Investors who are willing to invest in an IPO should only do so after conducting due diligence. The problem is that analyzing the IPO of a given company – its industry, financials, business model, technology, and more – can be a daunting task.
KingsCrowd is excited to extend its ratings and due diligence coverage to now cover exciting IPO opportunities on SoFi and Robinhood. KingsCrowd will help investors become more informed and better prepared to invest in IPOs on these online platforms.
Wall Street has Morningstar, S&P, and Bloomberg
The equity crowdfunding market has KingsCrowd.
About: Francis Vu
An investment professional with a background in private equity and venture capital having spent time conducting investments at VU Venture Partners and Pacific Oak LLC with a finance and management degree from Tulane University.