Have you ever watched the party that happens in Times Square each New Year’s Eve? Better yet, have you ever been in Times Square close to midnight on New Year’s Eve?

Everybody watches that big ball as it drops to the ground. They count off the seconds as it does. When it finally hits midnight, everybody at the scene breaks into a scream and starts singing. They kiss and hug each other. They even kiss and hug total strangers. They’re full of hope and expectation for the good fortunes that await them in the coming year. (Note: The last couple of years, maybe not so much.)

This scene is like what happens with an initial public offering (IPO). It’s a big event full of confidence and cheer. It’s the first step in a public company’s long, twisting road to success and immortality.

What’s an IPO? Can you get in on the fun? More importantly, should you? 

what is an ipo

What’s an IPO? How Private Companies Work Before One

Every business starts as a privately-owned company. It’s usually a sole proprietorship or a partnership. Ownership is limited to the people that start the business. For example, Amazon started when Jeff Bezos and his then-wife started selling books out of their garage. They were, at that time, the only two people who owned Amazon.

As the private business expands, it may attract attention from outside investors. They fund the growth of the business in return for a share of the profits. These investors could be friends, family members, venture capitalists, or some other investor group. While their shares represent wider ownership in the company, they’re still private owners.

Most privately-owned companies are content to stay that way. But a select few of them become massively successful. Business grows, more investors hop on, and operations expand. At some point, the business owner may realize that they need more capital to facilitate growth.

To get that done, they decide to switch over from private ownership. They offer shares in their company to the public. They put these shares for sale in the stock markets for the first time. Hopefully, investors take the opportunity in droves, buy up these new shares, and flood the company with new cash.

The moment this switch happens is called the company’s initial public offering, also known as IPO for short. 

How a Company Gets One

Getting to an IPO is a very long, involved, regulated, and expensive process. That’s partially why most private companies never become public. In fact, according to the Palm Beach Research Group, only 4,744 U.S. businesses were on the stock exchange in 2019. That’s out of a total of 32.5 million American businesses that were active that year. It takes at least 6 months for a company to go public after deciding to do so.

Finding an Underwriter

The first step in launching an IPO is to hire an investment underwriter. This person’s job is to analyze and prepare the private company’s financial data. This information is crucial to get right because potential investors will review it. So will the Securities & Exchange Commission (SEC), which regulates the stock market.

The report that the underwriter comes up with is called the preliminary prospectus. After reviews and revisions, it becomes the final prospectus and is released to interested parties and review boards.

Pricing the Shares and Promoting the Company

The SEC reviews the documentation and, hopefully, approves the company’s plan to go public. At this point, the underwriter — more likely, a couple of them — begin to prepare to release shares in the company to the public. They work with the company to set the number and price of shares that will be available.

Then, it’s a matter of making the company look attractive to new investors. Company officers often take to the road to present their case in person. That’s one reason an IPO can get very expensive.

Selling the First Shares (Pre-IPO)

Once the number of shares and price are settled, the SEC signs off on the IPO. That’s technically when it starts, but the shares aren’t made publicly available right off the bat. They’re first sold to investment banks, who immediately sell them to institutional investors. Some consider this to be the first of three stages of the IPO. Others prefer to think of it as the pre-IPO stage.

These first share-buyers are called the “primary market.” They’re the ones that the company has directly asked to invest when they went on their road trip (or however they were approached). They get the first crack at the shares, almost always for a lower price than what they’ll cost for the general public.

Releasing Shares to the Public

When that’s all sorted out, the company and underwriters settle on a final price that will be offered to the public on the first night. It won’t be as cheap as the price offered to the primary market. But it will be the lowest public price that the company ever expects to offer. (Yes — that’s a big risk.) The next day, shares go up for sale on the stock exchange for all other investors — the “secondary market” — to buy.

The company has now gone public and the adventure begins. Anyone with a brokerage account can buy shares in the business. 

what is an ipo

The Advantages

The biggest advantages of an IPO, as you may not be surprised to learn, involve money.

If a company’s IPO works as it’s supposed to, it receives a quick influx of operating capital all at once. New investors pour cash into the stock shares, depending on how many shares are available. This gives the company some immediate cash with which to fund expansion, operations, and employees.

More than that, IPOs offer the company’s first investors a chance to cash out at a big profit. Many of them choose to sell all of their remaining shares. These early investors are rewarded handsomely for their initial faith and contributions.

An IPO also generates a lot of publicity for the company. For many businesses, it will represent the single largest number of eyeballs they’ll ever get on their brand at one time. Only a few of them — your Apples, your Amazons, your Netflixes — will become true superstars in their fields. The rest of them will depend on the IPO to generate interest that they hope they will be able to sustain. Oftentimes, this is not the case.

Going public also gives companies another potential means of compensation for their employees. They can offer stock shares and options as part of their benefits packages. These can turn out to be profitable for employees and affordable for the companies. 

The Disadvantages

Only about 1% of all American companies are publicly owned. There are several reasons why a business might not pursue an IPO.

With the added publicity comes more scrutiny. Investors look at every move the company makes. They investigate news and earnings reports more closely. They take note of company leadership changes. All of these factors move the share price — and shareholders’ profits — up or down.

Public companies are also more closely monitored by the SEC. They must file a mountain of paperwork, starting with quarterly and annual earnings reports. They have to work under accounting regulations that are arduous and expensive. Private companies don’t have to abide by such firm standards.

Private owners who go public also give up a significant amount of control. They face the prospect of losing leadership of the companies that they built from scratch. Once, they only had to meet their own standards; now, they have to answer to thousands of shareholders they don’t know.

Finally, an IPO simply may not work. There have been a few that didn’t generate nearly enough interest or investment. Some businesses found their initial share prices dropping quickly after the IPO. That can wipe out years of hard work in a matter of months, if not weeks.  

Can You Get in on One?

What’s the IPO offer to retail investors? Can they get in on the action from the day company stocks go public?

Generally speaking, it’s not easy. It’s not impossible, but it’s very, very difficult.

Once the IPO is launched, it takes anywhere from 3 to 10 days to finally go public. Remember, institutional investors get the first crack at IPO shares. Because the IPO is a big risk, companies (and the SEC) want to make sure that the first wave of capital comes from trusted investors. The shares won’t be made available to public investors until the final day of the IPO.

Even then, it is hard for retail investors to get IPO shares. Forbes explains, “You’ll have to work with a brokerage that handles IPO orders—not all of them do.” The bigger your brokerage is, the likelier it will be that they will allow for IPO transactions. Think Schwab, Fidelity, TD Ameritrade, and the like.

And even then, you’ll have to meet certain requirements to get in on IPO shares. Most often, you’ll need to have a very high account balance with your broker. This minimum is never less than six figures. And it’s just in your brokerage account.

Your brokerage may require that you make a minimum number of stock transactions over a given period. The brokerages don’t want to risk IPO shares falling into the hands of inexperienced investors. So you need to be a very active trader who’s also very good at it — with the money to show for it. 

The Consolation Prize for Retail Investors

If your heart is set on investing in a company as close as possible to its IPO, the next best thing might ease your pain. In fact, it will probably be the better option.

That’s to wait until the stock has been on the exchange for a day or two. Wait until the stock shows up on your brokerage’s website with a “buy” button attached. Then buy in.

No, you won’t get the share at the rock-bottom price the primary market got it for. But if you sincerely believe that the company is going to be the next Amazon, you’ll still be extremely well off if you’re right. The price you paid will look like a bargain 20 years from now.

This may be the better choice anyway, for the simple reason that some IPOs don’t work. A company’s very first share price to the public may go down — way down.

Actually, it’s quite likely that it will. The company is still very new to the stock game and will experience growing pains. Those will come in the form of price drops. Some high-profile IPOs in recent years — notably, Lyft and Uber — experienced steep share price drops soon after going public.

So don’t let the high drama, excitement, and giddy optimism of an IPO fool you. And don’t feel left out if you can’t get in. You may be in a better position if you hold off until the party’s over and you can clean up what’s left. 

what is an ipo

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