What is an Initial Public Offering - IPO?

The process of offering shares in a private corporation to the public for the first time is called an initial public offering (IPO). Growing companies that need capital will frequently use IPOs to raise money, while more established firms may use an IPO to allow the owners to exit some or all their ownership by selling shares to the public. In an initial public offering, the issuer, or company raising capital, brings in underwriting firms or investment banks to help determine the best type of security to issue, offering price, amount of shares and time frame for the market offering.


Initial Public Offering (IPO) Explained

Key Takeaways

  • The process for making shares of a private company available to the public for the first time to raise capital is called an initial public offering or IPO.
  • The advantages of an IPO include ease in raising and accessing funds and conducting M&A activity.
  • The disadvantages of an IPO are that they require rigorous reporting and can be a distraction for founders from the main task of executing their vision.
  • Alternative methods to conducting a traditional IPO are Direct Listing and Dutch Auctions. While they are easier, the alternative formats involve investors taking on more risk.

Understanding Initial Public Offering - IPO

Some people refer to an IPO as a public offering or "going public." There are other ways to go public like a direct listing or direct public offering. When a company starts the IPO process, a specific set of events occurs. The chosen underwriters facilitate these steps.

  1. An external initial public offering team is formed, comprising underwriters, lawyers, certified public accountants and Securities and Exchange Commission (SEC) experts.
  2. Information regarding the company is compiled, including financial performance and expected future operations. This becomes part of the company prospectus, which is circulated for review after it has been prepared.
  3. The financial statements are audited, and an opinion is generated.
  4. The company files its prospectus and required forms with the SEC and sets a date for the offering.

IPO History

The Dutch are credited with conducting the first modern IPO by offering shares of the Dutch East India Company - often called VOC for short - to the general public. The company paid an annual dividend that ranged between 12% and 63% to its shareholders.

In modern times, IPOs have become a favored instrument of entrepreneurs to raise capital for future expansion. As a new industry gains prominence and its future prospects hyped by the media, startups in the sector capitalize by offering shares in their company to the public.

Companies in the technology sector are examples of this trend. Tech IPOs multiplied at the height of the dot com boom as startups without revenues rushed to list themselves on the stock market. 2008's financial crisis resulted in a year with the least number of IPOs. The market for IPOs has recovered since then but not so much.

Advantages of an IPO

The primary objective of an IPO is usually to raise capital for a business. However, a public offering has other benefits as well.

  • A public company can raise additional funds in the future through secondary offerings because it already has access to the public markets through the IPO.
  • Many companies will compensate executives or other employees through stock compensation. Stock in a public company is more attractive to potential employees because shares can be sold more easily. Being a public company may help a company recruit better talent.
  • Merger and acquisition activity may be easier for a public company that can use its shares to acquire another firm. Similarly, it is easier to establish the value of an acquisition target if it has publicly listed shares.

Some companies will conduct an IPO because of the prestige and credibility it imbues. This may be a factor for future lenders who might be more willing to make loans at more favorable terms if they know the company has a diversified shareholder base and is accountable to the SEC for accurate financial reporting. However, the real value of intangible advantages like prestige are difficult to measure.

Disadvantages of an IPO

An IPO is expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business. There are other disadvantages of an IPO as well.

  • Fluctuations in a company's share price can be a distraction for management, which may be compensated and evaluated based on stock performance rather than real financial results.
  • Strategies used to inflate the value of a public company's shares, such as using excessive debt to buy back stock, can increase the risk and instability in the firm.
  • A public company must file reports with the SEC that may reveal secrets and business methods that could help competitors.
  • Rigid leadership and governance by the board of directors can make it more difficult to retain good managers willing to take risks.

Having public shares available requires significant effort and expense that does not end after the IPO has completed. Public companies are also at risk of lawsuits and legal actions related to their public shares that can be expensive and distracting.

Alternative Share Offering Strategies

There are other methods to offer shares to the public besides an IPO. They share many of the pros and cons with an IPO but may be a better strategy for some companies.

Direct Listing

When an IPO is conducted, the investment bank or syndicate of investment banks will buy the shares from the issuer. The bank then plans to offer those shares on the secondary market, where they will trade on an exchange. In addition to fees, the bank may profit from selling the shares on the secondary market at a price that is higher than what it paid the issuer for the shares.

The investment banks that conduct the IPO will make a market for the shares and provide liquidity as they start trading. This is risky, so banks try to make sure IPO shares are priced so that the offering will be oversubscribed, which means there are more buyers for the shares at that price than will be available.

When the issuer conducts an IPO this way, the company is raising money from the investment banks and their clients rather than from the market directly. This method helps avoid some risks, and the banks can help promote the stock to increase its IPO price.

A direct listing, such as the one completed by Spotify Technology S.A. (SPOT) in 2018, occurs when a company simultaneously lists its shares on an exchange and offers ownership to the public for the first time. Direct listings skip the underwriting process, which means that the issuer has more risk if the offering does not do well, but issuers also may benefit from a higher share price. A direct offering is probably only feasible for a company with a well known brand and an attractive business. These kinds of offerings are referred to as a "hot issue" and can generate enough interest from investors on their own without the help of an investment bank.

Dutch Auction

In a Dutch auction, potential buyers are able to bid for the shares they want and the price they are willing to pay. The bidders who were willing to pay the highest price are then allocated the shares available. However, they will all pay the same price. For example, imagine there are 10 bidders vying for stock and the top three bidders are willing to pay $9, $8 and $7.50 per share. Between these three bidders, the company can raise the money it needs but will have to sell the shares to all three for $7.50 per share. This is very similar to the method used to sell U.S. Treasury bonds.

In 2004, Alphabet Inc. (GOOG) conducted its IPO through a Dutch auction. Other companies like Interactive Brokers Group, Inc. (IBKR), Morningstar, Inc. (MORN) and The Boston Beer Company, Inc. (SAM) have also conducted Dutch auctions for their shares rather than a traditional IPO.

An argument in favor of a Dutch auction is that it provides more information about the value of the shares than an IPO. The issuer has more transparency into the potential demand for the shares and can use that information to adjust the size of its offering and its expectations for the capital that will be raised.

IPO Performance

Traders can be distracted by survivorship bias and assume that buying shares after an IPO or from a direct offering is likely to be profitable. Studies have shown that, based on price performance, shares following an IPO have more than a 50% chance of being worth less than their offering price within three months of the offering.

There are several factors that may affect the short-term return from an IPO. Because the company is usually being promoted by investment banks, it is easy to set overly high expectations, which are then deflated once the market is more broadly aware of the company and its real value. Following an IPO, employees and early investors in the company may sell their shares as soon as they can in order to realize their gains. This selling can trigger severe declines if market conditions are poor or the company isn't performing well.

Blue Apron Holdings, Inc. (APRN) shares were available after their IPO on June 19, 2017, and the stock began falling right away before rising briefly following earnings in mid-December 2017. Unfortunately, the initial investors and employees whose shares were "locked up" or restricted from sale became available on Dec. 26, 2017, and the stock continued falling. This sequence is common among new companies and presents special risks for IPO investors.