What is an Initial Public Offering (IPO)?

An Initial Public Offering, or IPO, is when a company seeks to list its stocks/shares on a public stock exchange.

How do IPOs work? 

Companies can use an IPO to raise initial funds for a new project, or to access additional capital for expansion, growth, or to pay down debt.

As most investors can buy shares of a company for the first time following an IPO, this process can also help raise the profile of a company as it transitions to the public markets. An IPO can also improve the liquidity of a company’s shares, which can be very helpful to its management in a number of ways. 

It can allow founders, executives or staff to easily offload their existing shares without having to find a private buyer. It can also facilitate a company offering shares or stock options as part of their staff remuneration.

Why go public?

Going public via an IPO means you can raise capital quickly by reaching numerous investors, which you can then use to further your business.

For new companies, IPOs provide an opportunity to generate publicity by issuing shares, not to mention the prestige of being listed on a major stock exchange.

Companies can also use the lure of stock options to attract high quality employees to their business.

Underwriters and the IPO process

The IPO process requires an underwriter – an intermediary who facilitates the sale of stocks and guarantees a minimum price and/or a minimum number of stocks sold to ensure a successful launch.

Even though the IPO process can be a complex one, the following basic steps should still be followed. These are:

  • Appointing advisors 
  • Preparatory work 
  • Commencing institutional marketing
  • Lodging a prospectus with the governing body (ASIC in Australia)
  • Processing of listing application by governing body
  • Marketing and offer period, which may include a roadshow or tour
  • Closing the offer.

Corporate finance advantages

Since an IPO can result in a significant windfall of cash for a company as a result of selling ownership, this can give the company many advantages. It can use the proceeds to invest in its expansion, reward its founders, or pay out a dividend. 

Other advantages include:

  • Access to investment from the entire investing public to raise capital
  • Easier acquisition deals 
  • Improved credit borrowing terms compared to a private company
  • Lower cost of capital for equity and debt.

Corporate finance disadvantages and alternatives

Of course, there are some disadvantages to consider as well, such as:

  • The high expense of establishment and maintenance 
  • Requirement to disclose financial, accounting, tax, and other business information
  • Legal, accounting, and marketing costs are significant
  • High level management required for reporting
  • Loss of control and agency problems resulting from new shareholders
  • Increased risk of legal or regulatory issues
  • Employee retention difficulties due to rigid leadership and governance by the board of directors. 

Alternatives include remaining private or soliciting bids for a buyout.

Direct listing

Also known as direct public offerings, direct listings do not require a company to work with an investment bank to underwrite the issuing of stock. 

Although this provides the company with a quicker, less expensive way to raise capital, the opening stock price will be subject to market demand and potential market swings.

Dutch auctions

A Dutch auction involves the stock price being lowered until it has enough buyers to purchase all the available stock. For example, an IPO may have a variety of investors, all with a different share price they are willing to pay for the new shares on offer. 

This process allows the company to find a price for its shares that will allow all available shares to be sold at a price agreeable for all buyers by prioritising the investors willing to pay a higher price.

Investing in IPOs

Like all investments, investing in IPOs involves risk.

Although all IPOs come with a prospectus that outlines the company’s financial position and post-IPO plans, the reality is that a new public company cannot give investors as much information as one that has been listed for some time. As such, we tend to see a wide variety of outcomes for different IPOs. Some are incredible success stories, while others prove to be spectacular failures.

IPO performance

IPO returns are affected by many factors, some of which include:

  • Market factors, such as low/high interest rates, low/high unemployment, international exchange rates, etc
  • Industry factors that affect only a section of the economy: for example, airlines post-9/11 or post-COVID
  • Personal factors such as brand awareness or consumer comfort.

Key considerations for IPO performance

Valuing a company at the best of times is a complex and demanding task. But valuing a company that is about to IPO is even harder. IPOs tend to be younger companies in their growth phase, too. Some are not even profitable yet. 

This makes using traditional valuation metrics like the price-to-earnings (P/E) ratio very difficult for many IPOs, with investors often asked to look at other, less concrete metrics like revenue growth, customer retention or brand strength. While these numbers can be useful, they are not very conducive to valuing a company based on its future profits.

Lock-ups, waiting periods and flipping

Also known as ‘vesting’ or ‘golden handcuffs’, lock-ups refer to those who buy in, or are given shares, and may not be able to sell them for a year or more as part of the agreement.

These ‘lock-ups’ can help grease the wheels for an IPO by making sure a large volume of shares are exempt from being sold. This may help to prevent initial dips when the company does IPO due to the absence of any major selling activity early on.

Flipping is when you invest in an IPO and exit quickly, which some retail investors or institutions may be able to do.

This usually involves determining that a share’s set IPO price is below the company’s valuation. Getting on the right side of this equation can potentially result in a healthy profit on IPO day.

Tracking stocks

Most stocks can be tracked on the exchanges they are traded on.

You can also track them on other sites, such as Yahoo Finance, stockbroking sites, plus a variety of phone apps.

Long term IPO outlook

IPOs have been around for as long as stock exchanges, so they’re likely to remain a common channel for public capital raisings for the foreseeable future. 

The concept of the IPO has even been expanding in recent years. The cryptocurrency world has its own version of an IPO, the initial coin offering (ICO), sometimes called an initial token offering (ITO).

What makes an IPO a good investment?

Each and every IPO is different, and there are many ways an investor can assess an upcoming IPO as a potential investment. However, some may work for some companies and not for others. After all, if there was a perfect model for playing an IPO, we’d all be billionaires. 

But you can certainly master some basics to try and get ahead in this risky but potentially lucrative space.

If you do want to delve in, however, it is prudent to seek professional advice. 

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.