IPO (Initial Public Offering)

IPO Explained

An IPO, or Initial Public Offering, is where a company “goes public” by selling shares of stock to the public to raise money so that the company can expand and grow.

You probably already know that most companies are not public. Before a company is public, it is a private company and there is no way for the public to buy shares in the company. Accordingly, the company’s ability to raise money for growth and expansion may be limited.

If a company wants to grow, it can either use existing cash, borrow money from a lender and take on debt, or it can issue an IPO and sell shares of stock to the public. A company may not have sufficient cash to finance its growth plans, and it may not want to take on additional debt. By selling shares of stock to the public, it can raise capital and then use that capital to pursue its growth plans and strategy.

An example IPO

For example, suppose there is a small company called Heating Corp which is researching new home heating technology. This company might not initially need a whole lot of money to research potential designs for its technology in a small office somewhere, but once they reach the stage of launching their first product it could be a costly venture. They will now have to raise millions to build a factory, to purchase inventory and to hire employees for their factory. So, they hire an investment bank (also known as an underwriter) to launch an IPO. Our example company, Heating Corp, will work with the investment bank to generate a prospectus, which is a very lengthy document detailing all of Heating Corp’s financial statements and financial history as well as talking in detail about the company’s plans, how it will use the money it is raising in the IPO and the various risk factors of investing in the company. The investment bank will estimate the value the company, and the existing owners of the company will have to decide what percentage of the company they wish to retain ownership of and what percentage they would like to sell to the public via selling public shares.

Let’s say the owners want to own 60% of the company and the company’s value is $10 million. If the share price is set at $10, there will be one million shares. The owners will retain 60% of those shares, and 40% will be sold to the public. So, the owners will retain 600,000 shares, and 400,000 shares will be sold to the public in the IPO. The company in our example is a relatively small company to keep our example simple to understand. Most IPOs today that you hear about are for companies valued at over a billion dollars and often many billions of dollars. It takes money to make money.

When a company issues and IPO, it gets listed on a stock exchange so its shares can be publicly traded. Examples of stock exchanges would be the New York Stock Exchange or NASDAQ stock exchanges in the US. In order to get listed on a stock exchange, the company needs to meet the criteria for that stock exchange and also choose a ticker symbol. A ticker symbol is usually 3 or 4 letters that represent the company’s name or purpose in abbreviated form. For example, the ticker symbol for Facebook is FB. But a company can get creative and use something otherwise memorable. For example, Genentech is a biotech company and they use “DNA” as their ticker symbol.

What happens after the IPO?

Once the IPO is launched and the company goes public, the company’s performance is assessed by the public and the shares usually go up or down accordingly to how well the company performs. Often it is more about how well a company performs relative to the expectations. If it exceeds the expectations of the public, that’s usually when shares will go up.

Buying shares of an IPO is inherently more risky in most cases because the company does not yet have any track record as a public company so it’s not yet known how the company will perform after raising new money for its growth. There also is not yet any stock chart to look at.