IPOs are a monumental, hype-filled event for a company that helps drive their next stage of growth while enabling early employees and investors to cash out. They can also be exciting investment opportunities, despite being high-risk.

An IPO (initial public offering) is a special fundraising event that a private company goes through to become a publicly traded company. During an IPO, a private company sells new shares to public stock market investors with the help of an underwriter (i.e., an investment bank).

IPOs are complex and difficult processes that usually take from six to nine months to complete. Many of the most prolific companies in the world have gone through their own IPOs — and doing so represents a major achievement for the growth trajectory of any business.

Why do companies IPO?

A private company will choose to IPO for a variety of reasons. Generally, though, there are several common factors that will push private companies to IPO:

They want to grow faster and need more easily accessible money

Source: Giphy.com

Companies tend to go public when they are in a growth stage. To fuel this, a big infusion of cash is often needed.

Going public also provides these companies with easier future access to money from public market investors, as it can be raised through follow-on share sales or debt offerings — which is more efficient than raising money privately. This is especially helpful if a company is looking to grow via acquisition.

Early investors and employees want to cash out or get liquidity

Source: Giphy.com

By the time a company is ready to IPO or go public, it’s likely they have already received a few rounds of funding from private investors like venture capitalists.

It takes, on average, about 5 years for a company in the U.S to go public after receiving private financing, so it makes sense that existing investors want to see a big return on their investment for taking on such high risk. IPOs are a perfect way for this to happen.

Additionally, early employees and the company’s founders may also want to finally “cash out” on the years of blood, sweat, and tears they put into building the business. Through an IPO, founders and employees who have stock options get to finally see the money they had tied up in the company and can eventually sell their shares on the public market.

Read more: What you need to know if your job offers employee stock options

They want to increase their legitimacy and brand profile

Source: Giphy.com

An IPO is a big marketing event for a company and helps it solidify itself as a larger and more reputable business.

In the process of IPOing, significant media attention is generated for the company, its products, its leaders, and its overall growth story. This type of attention can attract new customers and new employees.

As a growing company, more media attention is usually a good thing (unless the IPO doesn’t go well…).

How does the IPO process work?

IPOs follow a structured process that starts with choosing an underwriter (investment bank) to lead the transaction.

Once that’s complete, the underwriter will conduct its financial due diligence while lawyers create a document called a prospectus and file an S-1 form with the U.S. Securities and Exchange Commission (SEC).

As this is done, the lead underwriter will establish a deal syndicate, which is a group of peer underwriters who will help market (or sell) the IPO to their clients. Following the lockdown of the syndicate and completion of all the financial and legal documents, the lead underwriter will start what’s called a company “roadshow.”

The roadshow is a quintessential IPO event. It allows company management to tell their organization’s story to prospective investors who may want to buy shares in the IPO.

At the conclusion of the roadshow, a pricing range for the IPO is set and interested investors submit their orders. To compensate early investors for the risk of investing, underwriters will typically price the offering lower than what they think market demand will bear. Doing this creates an immediate jump in the company’s share price, or “pop” at the open. This is a standard IPO practice.

If there is lots of investor interest when the underwriters are taking orders, the IPO may become oversubscribed, which can push the price even higher before the open.

The following day, the IPOing company typically gets to ring the opening bell at the exchange they listed on to open the market, and their shares start trading.

Read more: If you invested in these companies’ IPOs, how rich are you today?

Are there other ways for companies to go public?

An IPO is commonly thought to be the only way a company can go public, but this isn’t true. There are many ways for private companies to become publicly traded, each with their own pros and cons.

Direct listing

A direct listing enables a company to go public without an investment bank/underwriter. Existing shareholders of the company simply sell their shares to the public markets, instead of a bank doing it for them.

Since in a direct listing, the company’s goal is primarily to go public (versus raise money through selling new shares), direct listings tend to be a much faster and cheaper process and don’t come with the usual lockup periods that IPOs do.

Companies like Slack and Spotify, which have enough cash, are well-recognized brands, and have an easily understood business model, are examples of companies that have done a direct listing instead of IPO.

Reverse takeover (RTO)

A reverse takeover (or RTO) is a back-door alternative for companies looking to go public when they don’t have the financing requirements and profile needed for an IPO.

An RTO involves a private company purchasing a publicly traded shell company (a company without any active business operations or assets) and exchanging its own shares for the publicly traded company’s shares.

RTOs are typically a good option when there aren’t concerns about existing shareholder bases and if the company is looking to move quickly without the cost of an IPO. While they sound advantageous, RTOs often pose greater risks to investors than IPOs do.

SPAC (special purpose acquisition company) or “blank check company”

Until recently, SPACs were all the rage when it came to going public. In 2020, 248 SPACs worth $83 billion were launched, and in 2021, 613 SPACs worth $160 billion were launched. From SoFi to Virgin Galactic, it seems like everyone has been SPACing over the last few years.

To execute a SPAC, groups of investors raise money to put in a publicly traded shell company and then look for a private company to buy (hence, “blank check company”). When investors sign up to put money into a SPAC, they often don’t have visibility into the company that will ultimately be acquired. Similar to other options, SPACs are faster than IPOs.

Unlike IPOs however, SPACs are much riskier than IPOs, as investors are betting on the SPAC promoter’s track record, versus a specific company’s business. There’s also a reduced amount of regulatory disclosure and oversight required, which means these types of transactions are more subject to the hype train or occasionally fraudulent activities.

Can I invest in IPOs?

Investing in IPOs has typically been reserved for sophisticated investors and high-net-worth individuals. But given increased interest in IPO investing, more brokerages are beginning to offer their regular clients access to IPO stock.

TD Ameritrade, Charles Schwab, E*TRADE, Robinhood, and SoFi all offer some access to IPO stock — so long as you meet certain requirements. Although you may be able to purchase stock at IPOs now, be aware that doing so carries significant risks.

Read more: Best stock trading apps

IPOs historically have underperformed the market for up to two and a half years after going public and more than 60% of IPOs between 1975 and 2011 saw negative absolute returns after five years. This is because recently IPO’ed companies have significant growth expectations placed on them and have the propensity to become overhyped through the IPO process.

Additionally, there can be major valuation differences across public and private markets, so when the company becomes public, public investors might not place the same value on the company as its private investors did.

Lastly, newly IPO’ed companies are often not profitable and have difficulty becoming profitable fast enough to meet the demands of public market investors.

If you don’t want to take on the risk of investing in individual IPOs, there are ETFs (Exchange Traded Funds) available that let you invest in newly listed companies. Good examples of this are the First Trust US Equity Opportunities ETF (FPX) and the Renaissance IPO ETF (IPO). But again, be warned when looking at these types of investments as they are more volatile than the S&P 500.

Summary

IPOs are when a company “goes public” by selling new shares to investors on the public stock market. They’re typically done when a company needs fast cash for growth, for employees and founders to earn off their early investments, or to build a company’s brand profile.

While investing in IPOs used to be limited to more sophisticated investors, more and more brokerages are offering IPO stock to investors of all levels. Just keep in mind there’s always risk of an IPO not living up to its hype.

Featured image: eamesBot/Shutterstock.com

Read more:

Advertiser Disclosure – This advertisement contains information and materials provided by Robinhood Financial LLC and its affiliates (“Robinhood”) and MoneyUnder30, a third party not affiliated with Robinhood. All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. Securities offered through Robinhood Financial LLC and Robinhood Securities LLC, which are members of FINRA and SIPC. MoneyUnder30 is not a member of FINRA or SIPC.”

About the author

Total Articles: 8
Aubrey Chapnick is a side hustling freelance personal finance, business education, and careers writer who contributes to online and print media outlets in Canada like The Globe & Mail. He holds an MBA from the University of British Columbia and has several years of experience in the banking, investments, and technology industries. When not writing, he’s busy watching Formula 1, staying active, and managing his investment portfolio. All thoughts and opinions expressed by Aubrey are his own and not those of his current employer.