Initial Public Offerings: What is an IPO?

Almost nothing generates more excitement and buzz on Wall Street than when a well-known company launches its initial public offering (IPO). Legends abound of senior executives and secretaries who become multi-millionaires when the value of their company skyrockets overnight.   

IPOs are the stuff dreams are made of. But unless you own private stock in a company that’s about to “go public” it’s a dream that probably won’t come true. Here’s why.

What is an IPO?

First, let’s provide an IPO definition. An initial public offering is the first issue of stock a company allows public investors to buy. The main reason companies issue IPOs is to raise investment capital to fund R&D efforts, expansion into new locations and markets, add employees and boost sales, and marketing efforts.

Who benefits from successful IPOs?

Before it issues an IPO, the company is considered to be privately held. Private shares of company stock are owned mainly by the company’s founders, friends, family members, and early-stage institutional investors. Companies may grant these shares to rank and file employees as well.

These private shares are generally very illiquid and thus hard to value, but once the company “goes public,” shareowners are allowed to sell off some or all of their private shares in the IPO offering at a transparent price

When is an IPO issued?   

Most private companies wait until the firm has reached a mass scale and its management team is in place, and the company has already generated a great deal of positive buzz in the industry and popular media. After all, every private shareowner wants the price of the stock to climb as high as possible, so it makes sense to hold off the IPO until the time is right.

Can people outside the company participate in IPOs?

That depends. To Invest in IPOs you must have a brokerage account, which allows you to buy and sell stocks. You’ll need to meet the firm’s specific conditions to qualify to participate, such as having a minimum account balance of $100,000 or more or being an active stock trader.

Once you qualify, you generally need to sign up for upcoming notifications of IPOs that meet your specific investor profile. These notifications will often include a prospectus on the firm, which you should read carefully before you invest. You’ll also want to get your hands on as much independent research and media coverage of the company as possible, since this information may reveal risk areas that may limit the IPO’s upside potential.

Another important thing to research is the IPO’s underwriter. The underwriter is the entity, usually a broker/dealer or an investment bank, that evaluates the risk and determines the offering price of the IPO and then manages the process of issuing the security and selling pre-IPO shares to investors.

Private shareowners are generally given the first opportunity to convert their shares to pre-IPO shares at the initial offering price. Then other broker-dealers, institutional investors such as pension funds, hedge funds, and wealthy individual investors get a chance to purchase them.

Long term investors rarely profit from IPOs

On the day the IPO “goes public,” owners of these pre-IPO shares sell them to the public on the secondary market, such as stock exchanges.  

Studies have shown that most profits for IPOs are usually seen only on the first day of trading. As below chart by professor Jay Ritter at the University of Florida shows that IPOs have shown to underperform the broader market over the following three years.