What is an IPO?

What is an IPO? An initial public offering, or IPO, is the very first sale of stock issued by a company to the public. Prior to an IPO the company is considered private, with a relatively small number of shareholders made up primarily of early investors (such as the founders, their families and friends) and professional investors (such as venture capitalists or angel investors). The public, on the other hand, consists of everybody else – any individual or institutional investor who wasn’t involved in the early days of the company and who is interested in buying shares of the company. Until a company’s stock is offered for sale to the public, the public is unable to invest in it. You can potentially approach the owners of a private company about investing, but they’re not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of their shares to the public to be traded on a stock exchange. This is why an IPO is also referred to as “going public.”

What is an IPO?

How IPOs Work

A privately held company has some benefits that are forfeited once it goes public. For example, its owners do not have to disclose much financial or accounting information about the company. In the United States, it is easy and relatively inexpensive to found a private company, and most small to medium sized businesses are private. But large companies can be private too. For example, Hallmark Cards, Publix Supermarkets, Mars Candy, and IKEA are all privately held.

Public companies have thousands of shareholders and are subject to strict rules and regulations. They must form a board of directors and they must report auditable financial and accounting information every quarter. In the United States, public companies report to the Securities and Exchange Commission (SEC). In other countries, public companies are overseen by governing bodies similar to the SEC. In addition, public companies must adhere to regulations and requirements set forth by the stock exchanges where their shares are listed. Being on a major stock exchange carries a considerable amount of prestige. Historically, only private companies with strong fundamentals and proven profitability potential could qualify for an IPO and it wasn’t easy to get listed. Today, with competition among many stock exchanges, listing requirements have relaxed a bit.

How IPOs Work

The day before the stocks are issued, the underwriter and the company must determine a starting price for the stocks. A target price will have been set early on in the process, but IPOs are rarely stable. Obviously, the higher the price, the more money the company gets; but if the price is set too high, there won’t be enough demand for the stocks, and the price will drop on the aftermarket (the open financial markets where the stock will be traded after the initial offering). The ideal stock price will keep demand just higher than supply, resulting in a stable, gradual increase in the stock’s price on the aftermarket. This will lead to praise from market analysts, which will in turn lead to increased value down the road.

Who gets to buy the shares during an IPO is a complicated matter. In most cases, your typical, individual investor doesn’t get access to these offerings. Instead, the underwriter gets to allocate the shares to associates, clients, and major investors of his choosing. Most of the shares (about 80 percent) will go to institutional investors, which are major brokerage firms and investment banks, and a few high-profile individual investors. The remaining shares that do make their way to small-time, individual investors are hard to obtain: Stock brokers usually only offer access to IPOs to higher volume traders, traders with no history of flipping stocks, and traders with a long-term relationship with the broker.

After the initial offering, the stocks hit the open stock market, where they begin trading at a price set by market forces. IPO stocks tend to trade at a very high volume on that first day — that is, they change hands many times. Some IPOs can jump in price by a huge amount — some more than 500-1000 percent. Many IPOs do poorly, dropping in price the day of the offering. Others fluctuate, rising and then dipping again — it all depends on the confidence the market has in the company, how strong the company is vs. the “hype” surrounding it, and what outside forces are affecting the market at the time.

After about a month, the underwriter issues a report on the IPO, which is always positive. This tends to give the stock a slight boost. After 180 days have passed, people who held shares in the company prior to its going public are allowed to sell their shares.

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