What Is an Initial Public Offering (IPO)?

Investors wanting to know "what is an IPO" will need to understand their potential risks and rewards.

IPO on smartphone with "initial public offering" spelled out underneath
(Image credit: Getty Images)

The market for initial public offerings (IPO) is starting to heat up after a period of calm, which might have some folks wondering "what is an IPO?"

An initial public offering enables a private company to "go public," or start trading in public markets, by issuing its own shares on a stock exchange for the first time. In this way, any investor can buy shares and the company can raise capital to grow.

Investors can easily get caught up in the excitement and hype of an IPO's first day of trading. It's not uncommon for stocks to see gains of over 50% in their market debut.

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IPOs can be a great way for mom-and-pop investors to benefit from the strong growth of early stage companies. But it is important to understand this type of stock before jumping in.

Why do companies go public?

Most companies IPO primarily to raise capital. Typically, IPOs will raise over $100 million. But some hot IPOs can be enormous. Facebook, now Meta Platforms (META), Rivian Automotive (RIVN) and Uber Technologies (UBER) all raised billions of dollars from their IPOs.

The mid-September Arm IPO, arguably the the hottest upcoming IPO of 2023, raised roughly $5 billion for the Softbank-owned chipmaker.

While raising capital is usually the main reason for an IPO, there are other potential benefits for a company. First, an IPO allows a company's investors and employees to sell their holdings. They may have held on to their shares for a long time and want liquidity.  

Additionally, public companies can often recruit talented employees. These folks will find comfort in knowing the company's financials. There will also be opportunities to benefit from equity-based compensation like stock options.

What's more, an IPO can bring credibility to a firm. Because of the onerous disclosure requirements, larger clients may be more inclined to purchase the company's products.

What are the downsides to a company going public?

There are downsides too. The process of going public is not easy. The fact is that few companies meet the requirements that Wall Street investors demand. Usually, this means that annual revenues are over $100 million (or on pace for this within a year or two), growth is more than 25% and that the company demonstrates strong competitive advantages.

Another potential hurdle: Being a public company is expensive.  

"There are the substantial expenses related to preparing filings – like attorneys' fees or audit fees – or maintaining compliance reporting requirements," said Seth Farbman, cofounder and chairman of Vstock Transfer. "Depending on how long ago the company was incorporated or went through an IPO process, it may also be subject to other regulations applicable only at more mature stages in life cycles like Sarbanes-Oxley Act compliance rules for U.S.-based companies or International Financial Reporting Standards (IFRS) compliance rules for non-US based companies."

When a company does decide to launch an IPO, there are numerous steps in the process.

What is the IPO process?

The IPO process is highly regulated, and for good reason. The main statutes were passed in the early 1930s after the stock market crashed and the U.S. economy plunged in the Great Depression. The focus at that time was to provide more transparency for all investors.

Federal securities laws have also resulted in a fairly consistent IPO timeline. Let's take a look at the main steps:

#1 - Bake-off

Wall Street investment banks like Goldman Sachs, Morgan Stanley or J.P. Morgan will manage the process of the IPO. They are often called the lead underwriters of the deal (there will usually be two or three for an offering) and they will provide access to the institutional investors.

When a company decides to go public, it will start a "bake-off" process, interviewing a variety of Wall Street investment banks that compete to act as underwriters. Winning the assignment can result in substantial fees for underwriters – not just for the IPO, but for follow-on financings and acquisitions.

Over the past few years, some companies have bypassed lead underwriters. This process is called a direct listing and typically results in lower fees for the company. But a direct listing is really for those companies that have loyal customer bases and major brand recognition like Slack or Spotify (SPOT).

#2 - The Registration statement (Form S-1)

The lead underwriters will perform due diligence on the company, as will an outside law firm. Their findings will provide information for the registration statement, which is called an S-1. The S-1 includes the prospectus, with key details of how the company will operate, such as the business plan, risk factors, audited financials, management team bios, compensation and so on. The document is often well over 100 pages.  

Once the S-1 is finished, it will be filed with the Securities and Exchange Commission (SEC). But the first several drafts of the document will usually be confidential.  After this, investors can download a copy from the EDGAR database.

The SEC will go through a review process of the S-1 and may request that certain changes be made. These changes will become part of an amended S-1, which will also be published on EDGAR. There will often be several of these filings.

"Generally, the SEC's comments concern things that need to be disclosed better or more clearly or address gaps in the disclosure that need to be filled in for investors," said Megan Penick, partner and public securities chair at law firm Michelman & Robinson.  "While the SEC is not passing on the quality of any investment, through their review process, the company's registration statement should become clearer and have better and more fulsome disclosure."

#3 - The roadshow

The underwriter will set up a "roadshow," in which the company's senior managers will give their IPO investment presentation to investors across different states, and perhaps some countries. 

"These days, with Zoom and other electronic meeting platforms, most companies conduct road shows or test the waters presentations over Zoom," Penick said. "This eliminates travel and time costs and can make the presentation process quick for both for the company and for investors."

During the roadshow, the underwriter will get indications of interest from the investors. This process enables the underwriter to get a sense of the overall demand for the deal and to establish a price range, such as $14 to $16 per share. This information will be disclosed in an amended S-1.

#4 - The pricing meeting

On the night before the IPO begins trading, the company's senior managers and underwriters will meet to decide on the number of shares to issue and the price of the offering.  "Typically, the pricing of an IPO is determined by various factors, including the company's financial performance, current economic conditions, investor demand for the stock, industry-wide market trends and regulatory requirements," Farbman said.

No doubt, this can be a contentious meeting. Usually, the underwriters will want a lower price so as to allow investors to get higher gains. But the company's senior managers will try to get a higher price in order to raise more capital. Given that millions of shares are issued, a $1 change can make a big difference to both sides.

Is it good to buy an IPO?

IPOs can be a great way to invest in early stage growth companies. And yes, the gains can potentially be massive. If you invested $10,000 in the IPOs of Microsoft (MSFT) or Amazon.com (AMZN), you would have made millions.

Then again, the risks can be substantial. "Market history is littered with examples of 'hot' IPOs that have gone on to become market duds," said Ed Ciancarelli, senior portfolio manager at The Colony Group.  “Lyft, Inc (LYFT) went public at $72 on March of 2019 after pricing above the expected range of $62 to $68 per share.  LYFT closed the first day of trading at $78 and has not seen that level since.  Such broken IPOs become the victim of an overly exuberant market and unattainable expectations."  

So, an IPO should be considered a higher risk category for your portfolio. For example, it may be best to allocate no more than 5% to 10% in these types of investments.

Before investing in an IPO, you might want to wait until the excitement subsides. "Be patient and wait for the stock price to have its inevitable dip prior to investing," said Jeff McClean, CEO at Solidarity Wealth.  "Unless you are one of the lucky few who have access to pre-IPO stock at reasonable valuations, patience is the best course."

Moreover, it is a good idea to read the S-1. Here are some of the key areas to focus on:

Prospectus summary: This will be about 10 to 15 pages and is the first section of the S-1. It's essentially the executive summary of the business, which includes the description of the products or services, the market opportunity, the growth strategies, the growth metrics and so on.

Risk factors: These are mostly legal boilerplate. But some indicators are worth noting. For example, be wary of extensive litigation, widespread competition, or customer concentration. Another major red flag is a "going concern" opinion from the auditor. This means that the company will likely run out of money if there is no IPO.

Letter from the founders: This was started with the Google IPO and has since become popular, especially with tech companies. The letter can be a good way to get a sense of the long-term strategy of the company.

Finally, you should view the roadshow, which is available at retailroadshow.com. You will get a good overview of the company and a sense of the vision of the management team. Who knows, you may be seeing a presentation of the next Bill Gates or Jeff Bezos.

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Tom Taulli
Contributing Writer, Kiplinger.com

Tom Taulli has been developing software since the 1980s when he was in high school.  He sold his applications to a variety of publications. In college, he started his first company, which focused on the development of e-learning systems. He would go on to create other companies as well, including Hypermart.net that was sold to InfoSpace in 1996. Along the way, Tom has written columns for online publications such as Bloomberg, Forbes, Barron's and Kiplinger.  He has also written a variety of books, including Artificial Intelligence Basics:  A Non-Technical Introduction. He can be reached on Twitter at @ttaulli.