How IPOs Work

By: Ed Grabianowski & Patrick J. Kiger  | 

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The New York Stock Exchange evolved from a meeting of 24 stockbrokers under a buttonwood tree in 1792 on what is now Wall Street in New York City. ANGELA WEISS/Getty Images

What investor doesn't dream of getting in on the ground floor of some new company with a bold idea, and then watching it become the Apple, Microsoft or Amazon? That's why initial public offerings, or IPOs, are among the most exciting events in the business world.

IPOs involve companies that have grown up to a point by relying upon the resources of the founders, their friends and family, and a few early investors such as venture capital firms. But in order to get bigger and become more successful, they need more money than those sources can provide. So the company will file with securities regulators – in the U.S., that means the Securities and Exchange Commission (SEC) – to become a publicly-traded company. If the company is able to make it through regulatory scrutiny, it offers its shares for sale for the first time at an opening price that's designed to raise the money it needs [source: Fernando].

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In addition to raising capital for the company, IPOs also give the company's initial investors a chance to make a return that justifies the risk they took in backing it early on. Their own shares stand to grow in value as they become worth the price that they're trading on the stock market [source: Fernando]. And the legions of investors who buy shares in the newly-public company stand to watch their stake rise quickly in value as well, since IPOs typically are priced so that they go up 15 to 30 percent in value on the first day of trading, a phenomenon called an "IPO pop" [source: Roof]. Of course, they're hoping for an even bigger payday down the road. And they may get it. The top five performing IPOs between 2018 and 2021 each saw the value of their shares go up at least 10 times in value [source: van Doorn].

Of course, not all IPOs are such spectacular successes. Some don't see their shares rise much in value at the onset, and other companies perform disappointingly or even crash and burn.

In this article, we'll find out what an IPO is, why companies have them, and how people and companies make money with them.

The History of IPOs

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The Allbirds store in lower Manhattan in New York City, as the company was preparing an IPO, Aug. 31, 2021. Spencer Platt/Getty Images

It's easy to associate the idea of IPOs with technology companies, since those names are the ones that get the most hype in news media headlines. When social network company Facebook (now Meta) went public in an eagerly anticipated IPO in 2012, for example, it raised an astonishing $16 billion. And, although it was widely considered one of the biggest IPO flops of all time, it was the third biggest IPO in the history of American finance, and 10 times what another tech giant, Google, had raised eight years before [source: Markowitz and Carter].

But not every IPO is a tech giant. In 2021, for example, San Francisco-based environmentally friendly sneaker company Allbirds staged a successful IPO, raising $303 million, and seeing its shares sell at $15, above the expected range of $12 to $14. Allbirds' success had a lot to do with the growing popularity of its comfortable, minimalistic wool-top sneakers, which initially became popular in Silicon Valley and gradually developed fans across the U.S., and with the company's innovative use of renewable natural materials, rather than plastics and synthetics [source: Segran].

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IPOs aren't a new phenomenon. To the contrary, they date back to 1602, when the Dutch East India Company, at the time the biggest commercial enterprise in the world, invited every resident of the Netherlands to buy shares to help finance its trade in spices and other commodities [source: Petram]. In the U.S., IPOs date back to the late 1700s. The biggest IPO of that early period was the Bank of the United States, which raised $8 million from private investors in addition to $2 million from the federal government. Many of the investors were foreigners, something that didn't sit well with a lot of Americans. The bank's IPO didn't sell shares right away, but subscriptions, or "scrips," which were essentially a down payment on the stock. Nevertheless, when they were first offered in July 1791, they sold out so quickly that a secondary market in resale of scrips developed [source: Federal Reserve History].

In the centuries that followed, many familiar American companies built their businesses with the help of IPOs, and changed the U.S. economy in the process. In 1906, for example, Sears, Roebuck & Co., the retailer that popularized the concept of people ordering products and having them shipped to their homes, went public with the help of Goldman, Sachs & Co., a then-small New York-based investment banking firm that pioneered the idea of valuing stock offerings on a company's earning power and goodwill, instead of just its physical assets [source: Guzzetta, Goldman Sachs]. In 1956, Ford Motor Co. broke with the wishes of its recently-deceased founder, Henry Ford, and went public, staging what was at the time the biggest IPO in American financial history, selling $643 million worth of shares and immediately vaulting to No. 3 on the Fortune 500 list of the biggest public companies [source: Rosevear].

In 1980, Apple — a rising maker of a still-new product called the personal computer — staged its IPO, a crucial step on its way to becoming a massive global force that popularized digital music, the smartphone, and other innovations that have changed modern life. An investors who bought $1,000 worth of Apple shares back then and held them would have a stake worth nearly $1 million in early February 2022, which shows the alluring promise of investing in an IPO [source: Martin].

In the years that followed, numerous big-name American businesses raised capital through IPOs, ranging from Pepsi, Kraft Foods and MetLife insurance to AT&T.

Why Companies Have IPOs

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Traders work on the floor of the New York Stock Exchange in New York City. Spencer Platt/Getty Images

IPOs are a way for young companies to get bigger and more profitable, but established firms that have been in private hands for decades sometimes decide to do them as well. That's because IPOs, despite all the work that's required to do one and the need to endure regulatory scrutiny, often have big benefits for businesses.

For companies that need money to grow or to remain viable in the marketplace, going public might be the best — or the only – option available, if raising needed capital from venture capitalists, private investors or through bank loans is too expensive [source: Fidelity].

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In addition to funding growth and expansion, companies also use IPOs to pay down debt and reduce their interest costs. There's also the benefit of gaining public attention with an IPO and raising the company's profile in the marketplace. IPOs also provide a way to reward the founders and early investors who took a chance on the company when it was still a startup, because it often substantially increases the value of their ownership stakes. They can hold to those shares, or else sell all or a portion of their shares and walk away with a lot of cash, which can help them to diversity their investment portfolios or create more liquidity [source: Fidelity].

Another potential benefit of staging an IPO is that by becoming a public company, a business may seem more substantial and gain gravitas, which can help it to obtain better terms from lenders going forward [source: Fidelity].

At startup firms, IPOs also provide a way to reward employees. That's because startups often can't afford to pay big salaries, so they offer some of their compensation in the form of stock options, which give an employee the opportunity to obtain shares at a pre-set cost, called a strike price, at some point in the future. An employee can exercise that option and get shares for a price lower than what outside investors will pay, which in turn creates the opportunity to sell and make a nice profit [source: Mercado].

It's important to note that insiders can't realize those gains right away, because regulations require a six-month lockup period before they're allowed to sell their shares on the market [source: Li].

The Drawbacks of an IPO

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A trader works on the floor of the New York Stock Exchange at the closing bell in New York City. TIMOTHY A. CLARY/AFP/Getty Images

Having an IPO doesn't mean free money for the company. Otherwise, everyone would have an IPO. There are drawbacks that come with the new capital raised through an IPO.

The most obvious cost of having an IPO is the expense. It costs money to raise money. The legal fees, printing costs, and accounting fees associated with registering an IPO can run into the hundreds of thousands of dollars. On top of those costs, the rules for taking a company public are so complex that most companies have to hire experts to handle all the paperwork. Typically, those costs amount to seven to 10 percent of the amount of capital that an IPO raises [source: KPMG].

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And while new shareholders provide capital, they also can be a drawback of going public. The primary owners are no longer in a private company that can make independent decisions. The investors who purchased stocks at the IPO own a certain percentage of the business, and their demands cannot be ignored, even if they don't have a controlling interest (more than 50 percent of the shares) in the company. SEC regulations require shareholder notification, meetings, and approval for certain business decisions. Shareholders also want to see the value of their stocks rise, so if the stock price drops or remains stagnant, the company will have to deal with unhappy part-owners. If they become unhappy enough, they may sell their stocks, which will cause the value to drop further, decreasing the overall value of the company [source: Hunsaker].

After the IPO, there are additional costs for keeping up with filings required by the SEC regulations. Just complying with the requirements of the Sarbanes-Oxley Act, which was passed by Congress in the early 2000s in the wake of several financial scandals, can cost a company millions of dollars [source: McCann]. Public companies are also open to scrutiny both by the investing public and competitors, and their SEC filings contain a lot of information that anyone can look up.

There's also the risk that after doing an IPO, a company won't do that well after it goes public. It's not uncommon for a company's shares to soar when they debut on the stock market, and then quickly dip in value.

Ready, Set, IPO

Having an IPO is not so much an event as it is a process. It takes months of planning to prepare a company to go public. A board of directors must be assembled, accounts audited for accuracy, consultants and advisers hired, and a financial printer contracted. In fact, a whole cast of characters must take the stage to help an IPO happen.

The most important character is probably the underwriter, an investment banker who works for an investment company. Underwriters have the distribution channels and business community contacts that can get a company's shares out to the right investors. They will also help set the initial offering price for the stocks, work to create enthusiasm for the stock, and assist in creating the prospectus. The prospectus is an important document that describes the company in great detail to potential investors.

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Once the prospectus has been drafted, it is reviewed by the SEC. SEC approval only means that the prospectus follows the regulations for such documents – it says nothing about the quality or future profitability of the company [source: Sheffield and Wilks].

Following SEC approval, company executives go on the road show. This is a tour of major cities and cities where important brokerage houses have their headquarters. At these invitation-only slide shows, a few elite investors will even get one-on-one presentations [source: Sheffield and Wilks]. However, no one involved with the company is allowed to talk publicly about anything that isn't in the prospectus in the period leading up to the IPO.

The Day of the IPO

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Fresh Vine Wine co-owners Nina Dobrev (center, taking selfie) and Julianne Hough (center, in white dress) next to Fresh Vine Wine CEO Janelle Anderson and the executive team ring the closing bell on the day of their IPO at the New York Stock Exchange Dec. 16, 2021 in New York City. Craig Barritt/Getty Images

The day before the stocks are issued, the underwriter and the company must determine a starting price for the stocks [source: Hawk]. A target price will have been set early on in the process, but IPOs are rarely stable. Obviously, the higher the price, the more money the company gets; but if the price is set too high, there won't be enough demand for the stocks, and the price will drop on the open financial markets (where the stock will be traded after the initial offering). The ideal stock price will keep demand just higher than supply, resulting in a stable, gradual increase in the stock's price on the aftermarket. This will lead to praise from market analysts, which will in turn lead to increased value down the road.

Who gets to buy the shares during an IPO is a complicated matter. In most cases, your typical, individual investor doesn't get access to these offerings. Instead, the underwriter gets to allocate the shares to associates, clients and major investors of his choosing. Most of the shares will go to institutional investors, which are major brokerage firms and investment banks, and a few high-profile individual investors. These days, some online brokers offer what shares they're able to obtain to smaller-scale individual investors as well [source: Likos].

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After the initial offering, the stocks hit the open stock market, where they begin trading at a price set by market forces. IPO stocks tend to trade at a very high volume on that first day – that is, they change hands many times. Many IPOs do poorly, dropping in price the day of the offering. Others fluctuate, rising and then dipping again – it all depends on the confidence the market has in the company, how strong the company is versus the "hype" surrounding it, and what outside forces are affecting the market at the time.

After about a month, the underwriter issues a report on the IPO. This tends to give the stock a slight boost. After 180 days have passed, people who held shares in the company before its going public are allowed to sell their shares.

Originally Published: Aug 28, 2004

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