Initial public offering (IPO)

An initial public offering (IPO) is the first time a company sells its shares to the public on the stock exchange. Prior to an IPO, a company is private, with a small number of shareholders made up of founders and some key employees, venture capitalists or angel investors. Until a company’s stock is offered for sale on a stock exchange, the general public is unable to invest in it.

IPOs are also referred to as “flotations” and the process as “floating” or “going public”. It’s usually young companies who are trying to raise capital to expand or realise returns on their founder’s investments, but well-established firms also float.

Companies go public for a wide range of reasons. They may want to raise funds for expansion, and choose to do so by selling part of the company rather than borrowing the money. Alternatively, the current owners – perhaps the original founders, or a private-equity fund – may wish to “exit” (ie, cash in on their investment).

An IPO is underwritten by one or more investment banks, which typically earn large fees from the process. A prospectus with details of the company and the offering is issued to potential buyers. The IPO price is typically based on expected demand from investors. If demand outstrips the number of shares on offers (the IPO is “oversubscribed”), then the underwriter will have to decide how to allocate the shares. If there aren’t enough buyers, then the underwriter agrees to purchase the surplus (hence the term “underwriter”).

A newly listed company’s share price will often enjoy a “bump” on the first day of trading. However, unless you are allocated shares before the company starts trading – which is unlikely with a “hot” stock – then you are unlikely to benefit from this initial jump in price.

Many studies suggest that IPOs underperform over the long run. But some are more attractive to private investors than others. Privatisations, for example, can represent good opportunities, because the seller is the government, and the last thing the government wants is for potential voters to buy into the much-hyped sale of a public utility, only to find that their investment collapses within a few months of the IPO. That said, while Royal Mail’s shares near-doubled with a few months of their 2013 IPO, they have since struggled badly.

The advantages of going public include access to capital; the ability to use shares as a currency in future takeover deals; the ability to incentivise staff with shares; for founders to cash in value (“exit”); and to gain exposure and the credibility that goes with being public.

Firms that are loath to float – as it involves giving up some autonomy and sharing sensitive information with the market – tend to use the debt market (bonds) for finance instead.

A privately-held company does have some benefits that are forfeited by going public. For example, its owners do not have to disclose as much financial information or worry about fluctuations in their company’s share price.

These attractions, combined with the rise of plentiful private equity funding, have made going public less attractive to many founders (notably in the tech sector), at least until their companies are more mature.

This in turn has led to concerns about the shrinking of public markets, and about the fact that small investors are effectively being shut out of investing in some of the most attractive fast-growing companies around.

• See Tim Bennett’s video tutorial: A lesson from Facebook – avoid IPOs.