What Is an Initial Public Offering (IPO)?

Investors can reap big gains from IPOs, but understanding how a company goes public can help avoid pitfalls.

Letters of IPO with the Meaning Spelled Out
(Image credit: Getty Images)

An initial public offering (IPO) enables a private company to go public 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 of an IPO’s first day of trading. To raise the stock price and attract investors, the company will go all-out to build interest and buzz. The company’s senior management team often rings the opening bell of the stock market and ramps up an intense media campaign. For this reason, the share price of an IPO may jump sharply on the first day of trading.

IPOs can be a great way for mom-and-pop investors to benefit from big gains in growing companies. But it is important to understand this type of stock before jumping in.

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This year the IPO volume has declined precipitously. Some of the factors include rising interest rates and inflation as well as concerns about a recession. According to data from Dealogic, the amount raised from IPOs came to a mere $5.1 billion. This compares to more than $100 billion last year.

There is another type of public offering called a Special Purpose Acquisition Company or SPAC. This is a corporation that does not have an operating business. Instead, it raises capital by issuing shares on an exchange. The management team will then use the proceeds to acquire an operating business. SPACs have been criticized for their lack of transparency and more speculative nature than standard IPOs. SPACs have also declined in 2022, from $163.5 billion last year to $12.4 billion now, according to SPAC Research.

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, exceeding $1 billion, like Airbnb, Robinhood and Coupang.

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.

Second, 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.

The process of going public, however, 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 over 25% and that the company demonstrates strong competitive advantages.

Yet even if a company can meet these expectations, this does not necessarily mean that it will go public. Many companies have remained private for a prolonged period of time because they have had little difficulty raising capital from venture capitalists and private equity investors.

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

The Timeline of an IPO

The IPO process is highly regulated, and with 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 much 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.

#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, financials, management team bios, compensation and so on.

Once the S-1 is finished, it will be filed with the Securities and Exchange Commission (SEC). You can find the document at the EDGAR database at www.sec.gov.

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.

#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. This process has become mostly virtual since the Covid-19 pandemic.

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.

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.

Tips for Investing in IPOs

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 or Amazon, you would have made millions.

Then again, the risks can be substantial. Remember Pets.com? Or Webvan? They ultimately went bust in the dot-com bubble of the early 2000s.

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.

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.

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.