What is an IPO and how does it work?
Initial public offerings (IPOs) are the first chance most investors get to trade or invest in a company’s shares. Discover what an IPO is, and the process works.
What is an IPO?
An IPO is the process of a private company listing its shares on a public stock exchange – also known as ‘going public’. Initial public offerings (IPOs) are the first opportunity most investors get to buy a unit of ownership in a company and receive shareholder rights.
In an IPO, the shares that are being listed are new. All existing shareholders have to agree to create new shares and potentially dilute the value of their existing holdings.
Public share issues enable a company to raise money from the public, rather than relying on private capital. This opens up a much wider pool of capital the company can use to pay off its debts, fund initiatives and raise its brand’s profile.
When a company decides to list, it will offer its shares via investment banks, which are known as the underwriter of the transaction. These banks determine the level of interest in the company’s shares and the risks involved in the business’s decision, as well as suggesting the initial issuance price of the stock.
The underwriter will reach out to potential investors to engage them in a process known as subscription – this sets out terms such as how many shares each investor is interested in buying, and when the date of the issuance will be. Once it has been signed, the investor has agreed to terms and will make their payment.
After the company has IPO’d, each investor will receive their allocation and become shareholders. They’re now free to sell on the stock in an open market – known as the secondary market – without the company or underwriter’s involvement.
What does it mean when a company goes public?
When a company goes public, it means they become subject to specific reporting requirements and regulations from exchanges. While these can differ from exchange to exchange, in general a public company must have:
- At least two shareholders
- Issued shares to the public with a value of at least £50,000
- Been registered
- At least two directors
- A qualified company secretary
The regulations surrounding a public company also requires them to disclose all relevant financial information, as well as an analysis of their strengths, weaknesses and any future opportunities and challenges. This information is published in earnings reports, which companies publish quarterly or annually.
How does an IPO work?
An IPO works through a series of steps that a company has to take in order to sell new shares to the public for the first time. The whole process can take anywhere from six months to a year and can be delayed longer if there are any issues or if the firm decides not to list.
The entire process can be somewhat complex due to the number of legal requirements involved, but put simply, the steps are:
- Choosing a bank (underwriter)
The first step for the company is to choose an investment bank that will advise them on the rest of the IPO process. Usually they’ll decide based on the bank’s reputation and previous distribution history – this gives an indication of how many institutional and individual investors the company can offer its shares to in the IPO.
- Performing due diligence and meeting regulatory standards
The underwriter will act as a broker between the company and investors, but they need to put all the legal arrangements in place before any shares can be sold. At this stage the underwriter will also begin the process of registering with the exchange and reaching out to investors with a prospectus of information about the company.
- Deciding on an offer price
Once the IPO has been approved by the exchange and an IPO date has been set, the company and underwriter will decide on the offer price and the number of shares that will be sold. The price will depend on the company’s capital raising goals and the condition of the market. IPOs are often under-priced initially to encourage investment, but sometimes companies will over-estimate the interest in their shares and price the stock too high, which is why share prices can change so much on the first trading day. All the money raised from the newly-issued shares will go directly to the company – with a slice taken out for the underwriter’s commission.
- Providing analyst recommendations and creating a market for the shares
After the IPO, the underwriter will have to provide analysts’ recommendations and carry out stabilisation. This process ensures there are no order imbalances, usually through buying up any excess shares. There is only a short amount of time for the underwriter to do this, otherwise it becomes price manipulation.
- Opening of the secondary market
Once the IPO process comes to an end, the secondary market begins. This is when shares are traded freely between investors, without the company or underwriter’s involvement. It’s this secondary market that most retail investors and traders will have access to. So, when we talk about trading an IPO, it’s the secondary sale in question.
What does an IPO price mean?
An IPO price can mean two different costs: the offer price and the opening price. Both are important for traders to understand. The offer price is the value at which the company sells its shares to investors via its underwriter. The opening price is the subsequent value that shares begin to trade at in the public market – this is what most retail traders will refer to as the IPO price, as it’s the first price they can trade.
The difference between these two prices is of great importance, as it indicates whether or not the market believes the IPO was over or undervalued and the direction the share price could move in the short-term.
If the offer price is significantly higher than the opening price, then most investors aren’t willing to pay the IPO’s value – believing the shares aren’t worth what they were initially sold for. If the opening price is significantly higher than the offer price, it means the market believes the shares were priced below their actual value.
Alternatives to IPOs
Listing via an IPO is still the most popular way of going public, but there are a two other means that have gained in popularity in recent years.
- SPAC deals
Special purpose acquisition companies (SPACs) – also known as blank-cheque companies – are publicly-traded firms that buy out a private company that’s looking to raise capital through equity markets.
The SPAC purchases a stake in the company and then changes its ticker to reflect the new entity it’s merged with. SPAC deals mean that a company can go public without having to go through the process of an IPO, which is typically longer and more highly regulated.
Find out more about what a SPAC is.
- Direct listings
A direct listing, also known as a direct public offering or DPO, is a process through which a private company goes public to investors on stock exchanges without an IPO. In a DPO, a company lists existing shares rather than issuing new ones as in an IPO – so current shareholders and employees are able to sell their holdings to the public, without adding more common stock and diluting their value.
Direct listings mean there’s no need for an underwriter, so companies can go public with less preparation and fewer costs.
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What are IPOs FAQ
What does IPO stand for?
IPO stands for initial public offering. It’s a term used in the stock market to describe the first time a private company’s shares are made available for purchase by the general public. It is a new issuance of shares, which start trading on a stock exchange such as the London Stock Exchange or New York Stock Exchange.
How long does it take to IPO?
An IPO can take anywhere from six months to a year to happen once the company decides it wants to go public and can be delayed longer if there are any issues. For example, if there are less than advantageous market conditions, a firm might decide to wait to list for when investors are more eager to participate. A company can also decide at any point not to list at all.
How do you find IPO companies?
You can find IPO companies by keeping an eye on stock exchange listing boards or shares news. You’ll usually find analysis on confirmed IPOs as well as listings that are just speculative. It’s a good idea to do as much research as you can into a company before it lists.
You can find IPO companies on our upcoming IPOs page.
Is an IPO good or bad?
An IPO is inherently neither good or bad, it entirely depends on the company and whether you’re investing in it for the right reasons. It’s a bad idea to invest in an IPO just because the company has received some positive attention. And it’s always important to be wary of extreme valuations that have no basis in fundamentals – an overvalued stock at IPO is likely to sink quickly and take time to regain favour.
What happens to IPO money?
The money raised from an IPO goes directly to the company – with a slice cut out for the underwriter’s commission fees – and it can be used for a variety of different purposes. The most common uses of IPO money are: paying off debts, funding research and development, and raising the brand’s profile via marketing ventures.
What is a grey market IPO?
A grey market IPO is the trading of unofficial or over-the-counter shares that are not listed on a stock exchange. When you trade a grey market for an IPO, you will not be speculating on the true IPO price, but rather predictions of what the share could list at.
These markets are unregulated and trade outside of the IPO listing process.
What is a listing IPO?
A listing IPO is just another term used to describe the process of a company going public on the stock market. When a company is said to have ‘listed’ it means that its shares are now freely traded on the public market, ready to be bought and sold by investors.