Too embarrassed to ask: what is an IPO?

When a private company decides to sell shares in itself on the stockmarket for the first time, it conducts an “IPO”. Here's what that means.

Initial public offering (IPO) activity reached an all-time high in 2021 on the US stockmarket as many companies opted for IPOs due to the effects of Covid-19 and exceptionally high stockmarket activity. 

At the time of writing, there have been 1,010 IPOs on the US stockmarket; 134% higher since the same time last year, according to Stock Analysis. Several giants including financial services company Robinhood, cryptocurrency exchange Coinbase Global and dating website Bumble went public this year. 

There have now been more IPOs in 2021, than in the dotcom boom of the late 1990s, which saw more than 739 US firms go public in 1996. 

Rivian Automotive, a US electric-vehicle maker, posted the biggest IPO of the year when its shares debuted on the Nasdaq exchange. The company raked in $11.9bn, valuing the company at more than $100bn in the days after the IPO. 

But what is an 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, usually, 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.

The IPO process is also known as “floating”, “listing” 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 float, too.

How an IPO works 

An IPO is underwritten by one or more investment banks, which typically earn large fees from the process. They issue a prospectus to potential buyers with details of the company and the offering. 

The IPO price is typically based on expected demand from investors – if demand outstrips the number of shares on offer, the IPO is “oversubscribed” and 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.

What are the advantages of IPOs

If, as a reasonably long-term investor concerned with avoiding the permanent loss of your capital, you were given the choice of investing in a high-growth and exciting technology IPO or in a long-established company with what looks like a bit too much debt and whose best days appear to be very clearly behind it, the odds are you will choose the IPO.

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.

What are the disadvantages of an IPO?

What is at stake once a company who is initially private turns public? A privately-held company has benefits that clearly may be forfeited by going public.

As Investopedia points out, high costs can often deter companies from going down the IPO route. “Lawyers, investment bankers and accountants are required, and often outside consultants must be hired. As much as a year or more may be required to prepare for an IPO.”

Another disadvantage is that public companies typically face greater reporting requirements and are subject to greater regulatory oversight. A publicly listed company must make quarterly and annual disclosures about its financial health, among other things. 

By contrast, privately held companies 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.

But that being said, there are several reasons why companies may want to go public. A firm may want to raise capital to expand its business rather than borrowing from banks or in bond markets, so opting for an IPO is a good alternative way to raise funds. 

Another obvious benefit of going public is that companies can raise significant amounts of capital faster than they otherwise could, which in turn can help lower a company’s debt-to-income ratio and provide more capital for areas such as innovation, new products and advertisement spend. 

However, studies tend to show that IPOs underperform over the long run. Also, if IPO activity is particularly high, it’s often a sign of over-exuberance in the market and a warning that a crash might be around the corner.  For example, this is what happened in the year 2000 – which is when the dotcom bubble burst.

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