An initial public offering, or an IPO, is when a private company decides to go public and make its shares available to the public market for the first time. Many well-known companies have gone through the IPO process, such as Meta (Facebook) and General Motors. Going public is alluring for many private companies because they can raise a lot of capital in the public market.
In this guide, we’ll go over:
- How Do IPOs Work?
- What Is the IPO Process? 6 Steps
- Pros and Cons of IPOs
- Alternative Ways to Go Public
- Related Investing Skills
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How Do IPOs Work?
The concept of an IPO is relatively simple: A private company offers shares, or small pieces of ownership in the company, to the public. The public is then able to make money off the company’s future success, and the company has access to more money to grow and accomplish bigger goals.
While IPOs may be common for early-stage companies with high growth potential, that isn’t the only type of company that can go through an IPO. Rather, large companies that underwent bankruptcy and have restructured or reorganized may re-enter the public market through an IPO. Additionally, some big organizations may spin off parts of their company for a separate IPO.
Private companies wanting to go public typically find an investment bank to facilitate the process. This bank, also referred to as the underwriter, handles pricing estimates, roadshows, and paperwork, while consulting with management throughout the process. Additionally, the IPO process has heavy oversight from the U.S. Securities and Exchange Commission (SEC). The company will also need to apply to be listed on public stock exchanges, such as the NASDAQ or the New York Stock Exchange (NYSE).
What Is the IPO Process? 6 Steps
The steps for going from a private company to a public company include:
1. Finding an Underwriter or Investment Bank
It is important to choose an investment banking company that has a good reputation and that can distribute the initial shares to the audience the company wants, such as institutional investors versus smaller or individual investors.
2. Due Diligence and Filing
In this stage, the company and the investment bank agree on what type of underwriting they prefer. For example, an investment bank can agree to buy all of the shares of the company themselves and give the company an agreed-upon amount of money, or they can agree to try to sell as many shares as possible without any guarantee of how much the company will make.
The investment bank is also tasked with drafting certain documents for the IPO, including a “prospectus” that will be used to give details of the IPO to the public. Additionally, the company and the investment bank must file certain paperwork with the Securities and Exchange Commission (SEC) at this stage.
3. Setting a Price
The price of the IPO stock will be determined by the goals of the company, financial models of the company’s future growth and earnings, the condition of the economy, and how well the roadshows went. A roadshow is when the investment bank pitches the IPO to potential investors to gauge interest.
4. Launching the IPO
The SEC must approve an IPO before it can launch, but if the SEC gives its blessing and the company and investment bank have agreed to all the terms and share pricing, the company is ready to hit the market. Oftentimes, the IPO is announced in advance so investors know when to be ready to buy shares.
5. Stabilizing the Share Prices
Although there are SEC restrictions on manipulating market prices of stocks, those rules are suspended for a 25-day period after the initial launch of the IPO. During this time, the investment bank is able to buy and sell shares to keep the price favorable for their client.
6. Competing in the Market
At this point, the private company is now considered fully public and the investment bank gives control of the share price over to the public market. While the bank may still work with the company as a consultant, the price of the stock now depends entirely on the market.
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Pros and Cons of IPOs
Ultimately, going public isn’t always right for every company. And there isn’t ever a requirement for a company to go public — a company can stay private indefinitely.
Some advantages of an IPO include:
- Big capital potential: While an IPO is expensive for the company initially, companies can make a lot of money from the public market.
- Exposure: An IPO can involve a lot of press and interest in the future of the company, which may lead to more respect in its industry and better terms for future funding from lenders.
- Allow early investors to cash in: A key reason some companies launch an IPO is because the early investors are ready to cash in on their investments. Going public means those investors may be able to realize some profits from their early faith in the company.
IPOs are not without their disadvantages, though. Some downsides to going public include:
- Public companies have more transparency requirements: Once public, a company must disclose a lot of financial details to the public, including quarterly and annual financial statements.
- Some companies simply cannot qualify: Even if a company meets SEC requirements, it may not be able to find a bank willing to facilitate the process. After the 2008 financial crisis, and poor IPO returns throughout the COVID-19 pandemic, the IPO world is turning its focus towards “unicorn” companies — private companies worth more than $1 billion.
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Alternative Ways to Go Public
While IPO is the most common way for a private company to end up on the public market, it is not the only way. Other ways to go public include:
A direct listing is when a company does an IPO without any underwriting. This means that the company is taking on a lot of risk if the IPO is not well-received by the market. Oftentimes, a direct listing is only allowed for companies that have an existing brand presence and significant public interest.
In a dutch auction, the company and underwriters do not determine a price before the offering is public. Rather, potential investors place bids on how much they are willing to pay, and the shares go to the highest bidders.
Special Purpose Acquisition Company (SPAC)
A special purpose acquisition company (SPAC) is a relatively new way to enter the public market. Essentially, a shell company is created and made public with the sole purpose of buying a private company. Then, because the shell company is already public, the company it acquires becomes public, too.
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Related Investing Skills
Understanding what an IPO is and the process involved in going public is a core skill for investment bankers — facilitating IPOs is one of the biggest parts of investment banking. Other skills prospective investment bankers need to know include:
- Knowledge of special purpose acquisition companies (SPACs)
- In-depth understanding of trading concepts, such as stock options
- Business valuation practices, like discounted cash flow (DCF) valuation
- How to calculate financial metrics like compound annual growth rates (CAGRs)
Learn these skills using Forage’s Investment Banking Skills Passport.
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