In the trading environment of the stock market, a security’s debut on the public platform often sends the thrill of a lucrative catch through some investors. And this initial public offering (IPO) may certainly pay off for many investors at the end of its risk-versus-reward lure. But like moths drawn to a flame, a hot new stock also has the potential to burn those who jump too quickly and invest too robustly.
A company’s first publicly issued and sold stock is the short and simple IPO definition.
IPO Further Defined
To define an IPO further, other factors come into play such as the marriage of the stock market and the IPO – and the process that precipitates this. Once a company makes the decision to go public, it will have to take some clearly defined steps to remove itself from the private realm. The company becomes the “issuer” of the shares of stock it sells as it begins working with numerous entities to coordinate its IPO. As it seeks to raise capital for funding its operations, an issuer also typically enjoys other benefits from its public debut.
Public vs. Private Companies
In the broadest definition, a company is either private (privately held) or public (publicly traded). If a company “goes public,” this means it moves from private ownership to public ownership. Private companies typically are smaller, although this isn’t an across-the-board description.
Privately Held Companies
The tight niche of investors in a privately held company generally includes the company’s founder(s), families, friends and other investors such as angel investors (also known as private investors or seed investors) and venture capitalists (investors who supply the capital for startup ventures).
When a private company goes public, in a move that’s often referred to as an “exit strategy,” its early investors stand to profit from the investing risk they took in the fledgling company. As a result, the company’s IPO is usually comprised of shares that were initially owned by these private investors. As long as it’s privately held, a company is not required to disclose its financial information, but this perk of anonymity goes away when it goes public.
Publicly Traded Companies
Outside the limited scope of a private company’s investors, a public company’s investor pool cuts a wider swath. Generally, public companies count thousands of shareholders among their investors. Accountability requirements are far steeper on a public level than in the private sector. Publicly traded companies in the
Advantages of an IPO
Going public is only one option for a private company to raise capital for funding its growth. A company may also borrow funds or find additional investors. But offering IPO stock may be its fastest growth option because of the potential for raising more money in a shorter time frame.
Other IPO advantages include:
- Company/brand awareness. When a company goes public, its increased exposure may also promote increased sales.
- Mergers and acquisitions. A publicly traded company has better leverage to acquire other companies; on the flip side, it is attractive to other companies seeking acquisitions.
- Employee recruitment. A public company can woo good employees, including highly skilled management and executives, if stock shares are part of its hiring and/or benefits package.
Disadvantages of an IPO
An IPO can be an expensive undertaking, not just during the startup phase but also over the long haul, because of the ongoing costs and time investment associated with maintaining the company’s public status.
Other IPO disadvantages include:
- Full disclosure. A company’s financials, including tax information, are no longer a private matter.
- Loss of autonomy. When a company goes public, its former owner/management team must relinquish control over many business decisions. Shareholders get voting rights to make decisions through a board of directors.
- Competitor advantage. Certain public information, which companies are required to file, offers competitors a peek at financials and business methods/operations, which can be advantageous to the competition.
Steps to Establish an IPO
When a company decides to go public, the process involves more than just “putting itself out there.” Unless the company already has a strong management team in place, a business-savvy organization establishes a professional team with the necessary skill set to guide the company’s growth forward. With its team in place, the company then hires an investment bank to help it meet the SEC’s regulated requirements for selling securities. With a few exceptions, the bank coordinates a group of underwriters (instead of a single underwriter) to move the IPO deal forward.
Underwriting Process for IPOs
Most companies who launch IPOs must use an “underwriting syndicate” to facilitate their transition from private to public status. Underwriting syndicates are comprised of a group of underwriters who act as a go-between for the company and its investors. The underwriters purchase stock shares directly from the issuer, and the investors purchase stock shares from the group of underwriters.
Before trading even begins, the underwriters work with the company to determine the structural parameters of the security offering. Each underwriter doesn’t receive the same number of securities to sell, but through its collaboration with the company, the underwriting syndicate makes decisions about how the securities are allocated. The syndicate determines what percentage of the total offering will be offered to individuals and what percentage will be offered to institutions.
SEO and IPO Due Diligence
This initial underwriting process produces the underwriting agreement. After all the parties involved finalize the terms of the underwriting agreement, the SEC enters the IPO playing field. The lead investment bank must compile a registration statement, which it files with the SEC. This statement contains the company’s IPO details including its financial statements, management team structure and how the money that’s raised will be used. The registration statement also includes the company’s requested ticker symbol, which it will trade under when it goes public.
When the SEC receives an underwriting agreement, the IPO company enters a “cooling-off period,” during which it performs due diligence to ensure IPO compliance as well as full disclosure of required information. If everything meets muster, the SEC approves the IPO and establishes the effective date on which the company legally may offer its stock to the public.
IPO Red Herring Document
During a company’s cooling-off period while the SEC is performing its due diligence, the company compiles a preliminary prospectus, which is called its “red herring” document. The red herring contains the proposed structure of the IPO, prior to SEC approval, except for the price of shares and the date the company will go public. The company and its underwriters use this red herring document to “talk up” the IPO among potential investors.
What Is a "Hot" IPO?
Depending on how ardently a company and its underwriters court potential investors with the red herring document, an IPO may be considered a “hot” security. The IPO’s true popularity isn’t determined until trading actually begins, but the buzz around a particular security may cause its demand to exceed the supply of shares it offers. Underwriters typically offer “hot IPOs” to their cherry-picked clients because of the market demand for these securities. For this reason, individual investors may find it difficult to purchase these IPOs.
Once the whirlwind of trading begins for an IPO, the initial cost of shares may significantly spike in the first few days – or even hours – after a company goes public. Just as quickly, the price of shares may fall after this buying period.
IPO Stock Flipping
Flipping IPO stock loosely follows the house-flipping model: Buy low, sell high. An investor can purchase IPO securities while they’re “hot” and right out of the starting gate, and then sell quickly (within a few weeks or even a few days) before the price spike begins to come down.
However, keep in mind that the SEC provides a fair-warning disclaimer regarding this practice. If you’re an IPO flipper, you could quickly become persona non grata. Your brokerage firm might not sell you any more IPOs, or it might shut you out from buying another IPO for a lengthy time period – even though flipping is not an illegal practice.
The same rules don’t always apply to institutional IPO flippers. Be aware of this double standard because it could negatively impact you. Check your brokerage firm’s website to see its position on IPO flipping.
IPO Purchase Restrictions
A brokerage firm has the latitude to include (or exclude) IPO sales to its individual investors. Some firms require you to be an active trader with them or a subscriber of their premium services to qualify. Other firms may require you to maintain a minimum cash balance in your trading account. And sometimes, it’s not enough that you merely trade with a certain broker; you may need to be a frequent trader (sometimes with a large trading account) to qualify for IPO shares.
A firm typically discloses all its IPO purchase/trading restrictions on its website, which may be worth your research to check out if you’re a potential IPO investor.
IPO Lockup Agreements
After a few months of robust growth, many IPO prices plummet. A common reason for this drop in price is because of something called the "lockup agreement." As part of a company’s underwriting agreement, its employees, underwriters and other company officials may be required to sign the lockup agreement, which upon signing becomes a legally binding contract that prohibits company insiders from selling their stock shares for a certain period of time.
The SEC mandates a minimum time period of 90 days, but it does not place restrictions on the maximum time period, which is commonly a span of 180 days. Once the lockup period expires, there is often an immediate drop in stock prices because of a flood of people cashing in to make a profit on their investment.
SEC's EDGAR Database
The SEC offers some online research tools for consumers who want to research a public company's financials and details of operation. If you visit the SEC online at Investor.gov and enter “stocks” in the search box, you’ll be able to read a lot about these securities. Topics you’ll find include different types of stocks, an explanation of stock fees and the risks and benefits of investing in stocks. And if you enter “EDGAR” in the search box, you’ll pull up the searchable database for the SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) tool.
By using EDGAR, you’ll be able to research a company's IPO information such as whether or not the company has a lockup agreement and, if so, the agreement's terms such as the expiration date. Search by company name, fund name or stock ticker name, in addition to other search parameters. Although there are other websites where you can research a company or view its prospectus, the SEC notes that it neither endorses nor confirms the accuracy of the information or services included on these sites.
Video of the Day
- Investopedia: Initial Public Offering - IPO
- Investopedia: IPO Basics - Conclusion
- Investopedia: IPO Basics - What is an IPO?
- U.S. Securities and Exchange Commission: Initial Public Offerings, Why Individuals Have Difficulty Getting Shares
- Investopedia: IPO Basics - Getting In On An IPO
- U.S. Securities and Exchange Commission: Initial Public Offerings - Pricing Differences
- Investopedia: IPO Basics - Don't Just Jump In
- U.S. Securities and Exchange Commission: Initial Public Offerings - Lockup Agreements
- U.S. Securities and Exchange Commission: EDGAR Search Tools
- Corporate Finance Institute: IPO Process