There are thousands of companies that trade on the New York Stock Exchange (NYSE) and the Nasdaq. These companies range from the leviathan Apple to the smaller, more inconsequential companies, with market capitalizations of less than the price of a car.

Every last one of those companies had to start somewhere. They each sprang to trading life with initial public offerings (IPOs), turning from private companies to public ones, attracting investors and raising capital.

Key Takeaways

  • An initial public offering (IPO) is when a private company becomes public by selling its shares on a stock exchange.
  • Private companies work with investment banks to bring their shares to the public, which requires tremendous amounts of due diligence, marketing, and regulatory requirements.
  • Purchasing shares in an IPO is difficult as the first offering is usually reserved for large investors, such as hedge funds and banks.
  • Common investors can purchase shares of a newly IPO-ed company fairly quickly after the IPO.

How an Initial Public Offering (IPO) Works

IPO is one of the few market acronyms that almost everyone is familiar with. Before an IPO, a company is privately owned; usually by its founders and maybe the family members who lent them money to get up and running. In some cases, a few long-time employees might have some equity in the company, assuming it hasn't been around for decades.

The founders give the lenders and employees a piece of the action in lieu of cash. Why? Because the founders know that if the company falters, giving away part of the company won't cost them anything. If the company succeeds, and eventually goes public, theoretically everyone should win. A stock that was worth nothing the day before the IPO will now have value.

However, because their shares don't trade on an open market, those private owners' stakes in the company are hard to value. Take an established company like IBM; anyone who owns a share knows exactly what it's worth with a quick look at the financial pages.

A privately held company's value is largely a guess, dependent on its income, assets, revenue, growth, etc. While those are certainly much of the same criteria that go into valuing a public company, a soon-to-be-IPOed company doesn't have any feedback in the form of a buyer willing to immediately purchase its shares at a particular price.

An IPO is a form of equity financing, where a percentage ownership of a company is given up by the founders in exchange for capital. It is the opposite of debt financing.

The IPO process works with a private firm contacting an investment bank that will facilitate the IPO. The investment bank values the firm through financial analysis, comes up with a valuation, share price, a date for the IPO, and a tremendous amount of other information.

A business that plans an IPO must register with the exchanges and the Securities and Exchange Commission (SEC) to ensure it meets all criteria. Once all of the required processes are completed, a company will be listed on a stock exchange and its shares will be available for purchase and sale. This is one of the main ways a business raises capital to fund its growth.

Anonymity vs. Fame

The vast majority of NYSE and Nasdaq listed companies have been trading in anonymity from day one. Few people are concerned with every company listed on an exchange, especially ones that don't make a splash or control a significant amount of market share.

When most companies offer shares to the public, initially the news barely registers with anyone outside of the securities industry; however, when a highly publicized Facebook or Google walks into the room, most people take notice.

That's because such companies operate on the retail level or its equivalent. They're ubiquitous. There aren't hundreds of millions of people logging into their Cisco account to post photos multiple times a day, and no one makes a Hollywood feature film about people and companies that most of the population aren't interested in.

Fame can be a positive attribute as it requires little marketing to bring attention to the IPO and will more often than not result in high demand for the shares. Fame also comes with a lot more pressure, as investors, analysts, and government bodies all scrutinize every move of the popular company.

Can You, and Should You, Buy?

So why doesn't every investor, regardless of expertise, buy IPOs the moment they become available? There are several reasons.

The first reason is one based on practicality, as IPOs aren't that easy to buy. Most people don't have brokerage accounts, it takes time and money to open one, and even if you make it that far, placing a "buy newly issued stock X" order is harder than it sounds.

The company that's about to go public sells its shares via an underwriter; an investment bank tasked with the process of getting those shares into investors' hands. The underwriters give the first option to institutions, large banks, and financial services firms that can offer the shares to their most prominent clients.

If you invest in an exchange traded fund or a mutual fund, they may purchase the shares of an IPO, which is an easier way for you to gain exposure to the IPO.

When a stock goes public, the company insiders who owned the stock in the first place are legally prohibited from selling it for a fixed period—set by Securities and Exchange Commission (SEC) regulations—of at least three months. Up until that point, the insiders are rich only on paper.

The moment they can sell, they usually do—all at once. This, of course, depresses the stock price. It's at that point, with a glut of shares entering the market, that ordinary investors often get their first crack at what is now an IPO well along in its infancy.

The Bottom Line

The late and legendary Benjamin Graham, who was Warren Buffett's investing mentor, decried IPOs as being for neither the faint of heart nor the inexperienced. They're for seasoned investors; the kind who invest for the long haul, aren't swayed by fawning news stories, and care more about a stock's fundamentals than its public image.

For the common investor, purchasing directly into an IPO is a difficult process, but soon after an IPO, a company's shares are released for the general public to buy and sell. If you believe in a company after your research, it may be beneficial to get in on a growing company when the shares are new.