How IPOs Work: A Beginner’s Guide

What Is an IPO?

An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time. By going public, the company raises capital from investors and becomes listed on a stock exchange, allowing its shares to be traded openly.

IPOs are significant financial events that provide companies with access to substantial funding while offering investors an opportunity to own a stake in a growing business.

Why Do Companies Go Public?

Companies pursue IPOs for several key reasons:

1. Capital Raising – The primary motivation is to raise funds for expansion, research, debt repayment, or acquisitions.
2. Liquidity for Shareholders – Early investors, founders, and employees can sell their shares in the public market.
3. Brand Visibility – Public listing enhances credibility and attracts media attention.
4. Mergers & Acquisitions (M&A) – Publicly traded shares can be used as currency for acquisitions.
5. Employee Incentives – Stock options become more valuable when shares are publicly traded.

The IPO Process: Step by Step

The IPO process is complex and involves multiple stages, typically taking several months to complete.

1. Hiring Underwriters

A company selects investment banks (underwriters) to manage the IPO. Major underwriters include Goldman Sachs, Morgan Stanley, and J.P. Morgan. Their roles include:

• Determining the IPO price
• Marketing the offering to investors
• Ensuring regulatory compliance

2. Due Diligence & Financial Disclosures

The company and underwriters conduct due diligence, reviewing financial statements, business models, and risks. The company must file a registration statement (Form S-1 in the U.S.) with the Securities and Exchange Commission (SEC), which includes:

• Business operations
• Financial performance
• Risk factors
• Management details

3. SEC Review & Roadshow

The SEC reviews the filing for accuracy and compliance. Once approved, the company embarks on a roadshow, where executives and underwriters present to institutional investors to generate interest.

4. Pricing the IPO

Based on investor demand (book-building process), the underwriters set the IPO price. Factors influencing pricing include:

• Company valuation
• Market conditions
• Investor appetite

5. Going Public & Stock Exchange Listing

On the IPO day, shares are allocated to investors, and trading begins on a stock exchange (e.g., NYSE or Nasdaq). The stock’s performance is influenced by market demand, company fundamentals, and broader economic trends.

6. Post-IPO Stabilization (Lock-Up Period)

Underwriters may stabilize the stock price by buying shares if demand is weak. Additionally, insiders (executives, early investors) are typically subject to a lock-up period (90–180 days), preventing them from selling shares immediately.

Key Players in an IPO

Several entities play crucial roles in an IPO:

• Company (Issuer) – The business going public.
• Underwriters – Investment banks managing the IPO.
• SEC (Regulator) – Ensures compliance with securities laws.
• Institutional Investors – Large investors (mutual funds, pension funds) that buy IPO shares.
• Retail Investors – Individual investors who purchase shares post-listing.
• Stock Exchanges – Platforms where shares are traded (e.g., NYSE, Nasdaq).

Types of IPOs

There are two primary IPO methods:

1. Fixed Price IPO – The company sets a fixed price for shares before going public.
2. Book Building IPO – The price range is determined based on investor bids, allowing flexibility.

Alternative IPO models include:

• Direct Listing – Companies list without underwriters (e.g., Spotify, Coinbase).
• SPAC (Special Purpose Acquisition Company) – A shell company merges with a private firm to take it public.

IPO Valuation Methods

Underwriters use several valuation approaches:

• Discounted Cash Flow (DCF) – Estimates future cash flows and discounts them to present value.
• Comparable Company Analysis (CCA) – Compares the company to similar publicly traded firms.
• Precedent Transactions – Examines past M&A deals in the same industry.

Risks & Challenges of IPOs

While IPOs offer benefits, they come with risks:

• Market Volatility – Stock prices can fluctuate wildly post-IPO.
• Underpricing – Shares may be priced too low, leaving money on the table.
• Regulatory Scrutiny – Non-compliance can lead to legal issues.
• High Costs – IPO expenses (underwriting, legal, marketing) can be substantial.
• Performance Pressure – Public companies face quarterly earnings expectations.

How to Invest in an IPO

For individual investors, participating in an IPO can be challenging. Here’s how to get involved:

1. Brokerage Access – Some brokers (e.g., Fidelity, Robinhood) offer IPO allocations.
2. Buy Post-Listing – Purchase shares once trading begins.
3. IPO ETFs & Mutual Funds – Invest in funds that hold newly public stocks.

Famous IPO Examples

• Facebook (2012) – Raised $16B, faced initial volatility.
• Alibaba (2014) – Largest IPO at the time ($25B).
• Snowflake (2020) – Biggest software IPO ever.
• Rivian (2021) – Electric vehicle startup with a high-profile debut.

IPO Trends & Future Outlook

The IPO market fluctuates with economic conditions:

• Tech Dominance – Tech companies lead IPO activity.
• SPAC Boom – SPACs surged in 2020–2021 but faced regulatory pushback.
• Global IPOs – Asia (especially China) sees high IPO volumes.

Final Considerations Before Investing

• Research the company’s financials and growth prospects.
• Understand lock-up expirations that may affect stock prices.
• Assess market sentiment and economic conditions.

By understanding how IPOs work, investors can make informed decisions when participating in these high-stakes financial events.