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.

When a private company decides to sell shares in itself on the stockmarket for the first time, it conducts an IPO. This stands for "initial public offering". This process is also known as “floating”, “listing” or “going public”. 

Companies go public for a range of reasons. A company might want to raise funds to expand its business. Rather than borrowing the money from banks or in the bond markets, it might choose to sell part of itself to institutional investors (such as pension funds) and sometimes also to individuals (often described in the City as "retail investors"). Alternatively, the existing owners – who could be the people who founded the business, or even a private equity fund who previously bought the business – might want to "exit". That's financial market jargon for "take the money and run".

So how does an IPO work? The deal is underwritten by one or more investment banks, who will typically earn large fees from arranging and advising on the process. A prospectus with details of the company and the terms of the offering is issued to potential buyers. The share price at which the company goes public is based on demand from investors.

If the IPO is oversubscribed – in other words, demand for the shares is higher than the number of shares on offer – then the underwriter will have to decide how to dish them out. If there are too few buyers, then the underwriter will buy the extra shares. Hence the term "underwriter". 

Sometimes an IPO will be pulled at the last minute, but this is rare. What tends to happen instead is that companies try to go public when markets are hungry for new listings. That means they can raise more money, the investment banks can make bigger fees, and early investors feel happy because they quickly make money on their investment.

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, the year 2000 – which is when the dotcom bubble burst – still holds the record for the most IPOs to come to market in a single year ever. For more on IPOs and bubbles, subscribe to MoneyWeek magazine.

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