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How IPOs Work

By: Ed Grabianowski & Patrick J. Kiger  | 

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].

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