Going public with an initial public offering, or IPO, is a big step for any company. It often attracts a lot of attention from both large institutional asset managers and individual investors.
An IPO is the means through which a private company starts trading on the public market. This makes its financial details and ownership structure available to investors worldwide.
What Is IPO?
An IPO is the process through which a private company first offers its shares to the public and lists them on a stock exchange. Prior to this, ownership usually belongs to founders, employees, venture capital firms, or private equity investors.
After an IPO, anyone with a brokerage account can buy and sell these shares on public exchanges, such as the New York Stock Exchange or the London Stock Exchange.
Why Do Companies Go For an IPO and When Is It Necessary?
Companies decide to go public for several reasons. Mostly, they do it to raise money without taking on more debt. They can use these funds for expansion, research and development, acquisitions, or to pay off existing debt.
An IPO also offers liquidity for early investors and employees who might want to sell some of their shares. For instance, venture capital funds often have fixed lifecycles, usually 7 to 10 years. An IPO can be their exit strategy, allowing them to cash in on their initial private investments.
Also, being publicly listed can boost customer confidence and make a company more transparent. This can help it grow internationally and attract talent through stock options.
However, becoming a public company is not always the right move. Doing so means extensive disclosure requirements and increased scrutiny. That’s why many large private companies choose to stay private for longer.
How does an IPO work?
An IPO is a structured and regulated process. It starts when a company picks investment banks to be its underwriters. These banks help with things like figuring out valuation, how the deal should be set up, and pricing.
Once the underwriters are on board, the company files a registration statement, including a prospectus, with the Securities and Exchange Commission (SEC). This document then goes public. Just remember, though, the SEC’s review of the filing doesn’t mean they endorse or approve the IPO’s potential.
Next up is the “roadshow” stage. Here, company executives and investment bankers present the company to institutional investors in major financial hubs. They are looking to gauge interest and assess demand.
After the roadshow, the company and its underwriters set the offering price, considering market demand and current conditions.
Institutional investors usually get their share allocations first. Retail investors, however, often buy shares at a higher price once trading begins on the exchange. For instance, DoorDash was priced at $102 per share but opened trading at $182 .
Finally, the shares get listed and start trading. Insiders usually are not allowed to sell their shares for a set time, often 180 days. This is called a lock-up period.
What Does an IPO Performance Signals About a Company?
An IPO’s market performance can tell you a lot about both general investor sentiment and a company’s core strengths.
Short-term performance, especially the first-day return, draws a lot of attention. Studies show U.S. IPOs since 1980 have averaged 18-19% in first-day gains. Underwriters often deliberately underprice shares to ensure a successful launch and reward early investors.
On the flip side, poor trading can be just as telling. For example, Cerebras, an AI company that went public in 2023 saw its stock price drop over 20% from its initial closing price. This kind of drop often means the market thought the initial valuation was too steep, revealing how market excitement and a company’s true value don’t always align .
But big first-day gains don’t always mean a company will do well for years. Some IPOs that shot up early on have later fallen sharply once the initial buzz wore off. Therefore, early IPO performance might tell us more about how the market received the company than its actual long-term worth.
If a stock performs consistently well after the initial lock-up period, usually six months, that’s a good sign. It often suggests executives and founders are confident in the company’s long-term plan.
The first earnings report after the IPO and when the lock-up period ends is another important signal. When a stock holds its value even after insiders can sell, and its quarterly results match what the company promised in its prospectus, that shows real strength.
When should investors keep off an IPO?
Not every IPO makes a good investment for everyone. Investors should watch for several warning signs that might make them want to steer clear. For example, high valuations relative to sales or earnings, especially for companies still losing money, often end up disappointing investors.
If existing shareholders are selling off a lot of stock during the offering, it could mean insiders think current prices are good exit points. A short financial history or heavy reliance on just one product or customer also adds a lot of risk.
Companies burning through cash with no positive free cash flow also deserve a closer look. This is especially true when interest rates are climbing, which can really hurt how companies are valued.
Sometimes, an IPO valuation is set much lower than previous private funding rounds. That might signal private investors are trying to get out because market conditions aren’t great.
The timing of the IPO in relation to market trends is also important. Historically, IPOs launched during periods of intense sector excitement or high overall market valuations have often ended up giving weaker returns. For example, Ritter and Welch’s research on the dot-com boom and burst of 1999 and 2000 showed average first-day returns hit 65% right before the dot-com bubble burst.
A prudent approach involves carefully reviewing the IPO prospectus, comparing the company’s financial metrics against those of established competitors, and assessing whether the projected growth narrative remains credible at the post-IPO valuation.
What is an IPO?
An initial public offering is a private company’s first sale of shares to the public, after which its stock trades on an exchange.
What is the primary purpose of an IPO for a company?
An IPO enables a private company raise capital from public investors, gives early shareholders liquidity, and boosts its visibility once its shares are listed on an exchange.
How is the IPO offer price typically determined?
Underwriters weigh the interest from institutional investors during the roadshow then set the final price using that feedback, staying within a range announced earlier.
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