How IPOs Work: A Step-by-Step Explanation

1. Understanding IPOs: The Basics

An Initial Public Offering (IPO) is the process through which a private company transitions into a publicly traded entity by offering its shares to the public for the first time. This allows the company to raise capital from investors while providing liquidity to early stakeholders.

Key IPO Participants

• Issuing Company: The private firm going public.
• Underwriters: Investment banks (e.g., Goldman Sachs, Morgan Stanley) that facilitate the IPO.
• Regulators: The Securities and Exchange Commission (SEC) in the U.S. ensures compliance.
• Investors: Institutional and retail buyers purchasing shares.

2. The IPO Process: Step-by-Step

Step 1: Hiring an Investment Bank (Underwriter Selection)

The company selects one or more investment banks to underwrite the IPO. The underwriter assesses the company’s financial health, market potential, and valuation.

• Lead Underwriter: Manages the IPO process.
• Syndicate Underwriters: Assist in share distribution.
• Types of Underwriting:
  • Firm Commitment: The underwriter buys all shares and resells them.
  • Best Efforts: The underwriter sells shares but doesn’t guarantee full subscription.

Step 2: Due Diligence & Documentation

The underwriter conducts extensive due diligence, reviewing financial statements, business models, and legal compliance.

Key Documents Prepared:

• Registration Statement (Form S-1 in the U.S.): Filed with the SEC, includes financials, risks, and business details.
• Preliminary Prospectus (Red Herring): A draft document shared with potential investors, excluding the final share price.

Step 3: SEC Review & Approval

The SEC reviews the registration statement for accuracy and compliance. The company may need to address SEC comments before approval.

• Quiet Period: After filing, the company must limit promotional statements to avoid influencing investors unfairly.

Step 4: Pricing the IPO

The underwriter and company determine the IPO price based on:

• Financial Performance: Revenue, profits, and growth prospects.
• Market Conditions: Investor demand and economic trends.
• Valuation Methods: Discounted Cash Flow (DCF), Comparable Company Analysis.

Price Range & Final Pricing

• Initial Range: Set in the Red Herring (e.g., $20-$25 per share).
• Final Price: Decided a day before the IPO based on investor feedback.

Step 5: Roadshow & Investor Marketing

The company and underwriters conduct a roadshow, presenting to institutional investors (hedge funds, pension funds) to generate demand.

• Key Roadshow Components:
  • Business model explanation.
  • Financial projections.
  • Competitive advantages.

Step 6: Share Allocation & Stabilization

• Institutional Investors: Receive most shares due to large order sizes.
• Retail Investors: May get limited access via brokerage firms.
• Greenshoe Option: Underwriters can sell 15% extra shares if demand is high.

Step 7: IPO Launch & Trading Begins

On the IPO day:

• Shares are listed on a stock exchange (e.g., NYSE, NASDAQ).
• Trading begins, with prices fluctuating based on supply and demand.

First-Day Performance

• Pop: Shares surge above the IPO price (e.g., Facebook’s rocky debut vs. Snowflake’s 111% jump).
• Drop: Shares fall below the IPO price if demand is weak.

3. Post-IPO Considerations

Lock-Up Period

Insiders (executives, early investors) are restricted from selling shares for 90-180 days to prevent market flooding.

Market Performance & Analyst Coverage

• Analyst Reports: Underwriters publish research, influencing stock movement.
• Volatility: Newly public stocks often experience sharp price swings.

Corporate Governance Changes

• Increased Scrutiny: Public companies must disclose financials quarterly.
• Shareholder Meetings: Investors vote on major decisions.

4. Risks & Challenges of an IPO

For Companies

• High Costs: Underwriting fees (5-7% of capital raised), legal expenses.
• Loss of Control: Public shareholders influence decisions.
• Regulatory Burden: Compliance with SEC reporting requirements.

For Investors

• Volatility: Early trading can be unpredictable.
• Overvaluation: Some IPOs are priced too high, leading to post-IPO declines.

5. Alternatives to Traditional IPOs

Direct Listing (e.g., Spotify, Coinbase)

• No underwriters; shares are directly sold to the public.
• Lower fees but no capital raised (only liquidity for existing shareholders).

SPAC Mergers (Special Purpose Acquisition Companies)

• A shell company raises funds via IPO to acquire a private firm.
• Faster than traditional IPOs but riskier due to less scrutiny.

6. Notable IPO Examples & Lessons

Successful IPOs

• Google (2004): Priced at $85, now worth over $1,700 (adjusted for splits).
• Alibaba (2014): Raised $25 billion, the largest IPO at the time.

Failed IPOs

• WeWork (2019): Withdrew IPO due to valuation concerns and governance issues.
• Snapchat (2017): Shares dropped post-IPO due to slowing user growth.

7. How to Invest in an IPO

For Retail Investors

• Brokerage Access: Some platforms (Fidelity, Robinhood) offer IPO participation.
• Buying Post-IPO: Purchase shares once trading begins.

For Institutional Investors

• Pre-IPO Allocations: Large investors get priority access.
• Long-Term Holding vs. Flipping: Some hold for growth, others sell quickly for profits.

8. The Future of IPOs

• More Tech Unicorns: Companies like SpaceX may go public.
• Regulatory Changes: SEC may adjust rules for SPACs and direct listings.
• Global Trends: Increasing IPOs in emerging markets (Asia, Middle East).

This structured breakdown ensures clarity on the IPO process, helping investors and businesses navigate this complex financial milestone.