How Does An IPO Work?

IPOs are dominating headlines this year — Lyft made it’s debut in March, Pinterest recently went public, and today, Uber execs rang the bell. Amidst all of the buzz, we wanted to take a pause to address some FAQs around IPOs: how does an IPO work? Should you invest in an IPO stock?

What is an IPO?

Think of an IPO as a type of exit strategy for early private investors, and a means for the company to raise additional capital from the public market. It is the mark of a transition from a private company to a newly minted public company traded on an exchange. This requires publicly disclosing financial statements and adhering to the much stricter regulation of the Securities and Exchange Commission (SEC), which private companies are not subject to. During the IPO process, a company will file an SEC Form S-1 which is the initial registration form required for any new security containing important information about the company and meant to serve as the key source for due diligence along with the Prospectus available to potential investors.

How Does An IPO Work?

So how does an IPO actually work? Once a company decides to go public, they start by hiring an investment bank to facilitate the process. The deal can be structured as either a firm commitment where the investment bank agrees to buy the entire offering at a discount and resell it to the public -OR- on a “best-efforts” basis, where the bank just brokers the deal and sells the shares directly to the public with no guarantee to the company.

Typically, the top investment banks underwrite an IPO on a firm commitment basis.

Usually there is a kind of bidding process amongst different banks, and the company will choose one or more investment bank(s) to serve as the underwriter(s), with one bank serving as the lead underwriter.

The lead underwriter leads the syndicate of the selected banks (created to spread risk across multiple entities), and market the offering. They go on roadshows to market the shares to institutional investors, gauge interest, and hype up the offering. For the most part, retail investors will not be able to participate at this stage and can only invest in an IPO once shares begin trading on an exchange.

The spread between the IPO price (the price at which shares begin to trade in the open market) and the offering price (the price at which the company offers shares to investors) is what makes up the investment banks’ profit. When there is more demand for an IPO than the number of shares offered, it is considered “oversubscribed,” which creates even more hype around the offering. There is typically a good amount of volatility when a new stock begins trading as part of the price discovery process that balances supply and demand.

Should I Invest in IPO Stock?

As exciting as investing in an IPO sounds, it is a risky endeavor. It’s especially risky for the individual investor who is the last in the pecking order for an opportunity to buy the stock “early”.

The deck is stacked against you, and investing in IPOs has not generally been a profitable decision for the individual (see this FPA article on IPO Historical returns).

The bottom line is, investors should be aware that there is significant uncertainty around an IPO. These are unestablished companies without a proven track record and that have not been subject to Wall Street’s expectations — this can potentially put individual investors at a disadvantage.

Read More: Your Guide to Stock Options


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