What are IPOs?

IPOs – A Breakdown

Apple. Amazon. Facebook. These well-known tech giants were once startups. Private companies with only a small number of shareholders.

Most companies have humble beginnings, sometimes funded by the savings of the founders, or by investments from family and friends. In some instances, these private companies do very well.

To continue their growth, they will likely need more capital (money). One way of raising this capital is by taking the company public through an Initial Public Offering (IPO).

What is an IPO?

An Initial Public Offering is a process through which private companies offer shares to the public via the stock market for the first time.

A private company often has a small number of shareholders including early investors. This could include the founders, family and friends, as well as professional investors.

Taking the private company public allows a wider audience of investors to purchase shares in the company and become shareholders. By issuing (selling) these new shares, a company can raise capital, which could be used to help fuel growth. It also gives access to investors who had previously been unable to invest in the company.

How do IPOs work?

An example.

A private company has 10 existing shareholders, each with a varying shareholding percentage. The company decides they want to raise capital and allow public investors to buy shares in its company via an IPO. This is often described as 'going public'. The company plan to issue a certain number of new shares, each with a percentage stake in the company. The number of shares issued can vary from company to company.

The company hires advisers which include investment banks, accountants and lawyers and are collectively known as the ‘Origination Team’. The origination team help to facilitate the process for the company, produce the paperwork and negotiate meetings with potential investors to stir up demand for the soon-to-be available shares.

A ‘prospectus’ will then be produced and released. This is a legal document produced by the company, which includes a host of relevant information for investors. This may contain company objectives, performance, risk, expenses, policies and much more. Companies must give a full and fair description of the business, to allow investors to make more informed decisions.

An application process will then be opened, known as the ‘offer period’. The offer period can last a week or more. This gives investors time to assess the offer information and submit bids indicating the number of shares they are willing to purchase and the price they are willing to pay. During this period, no individual investor knows how much demand there is from other investors. When the offer period closes investors are allocated the shares based on their applications. Sometimes investors may not receive their full allocation if the offer has been ‘oversubscribed’.

An initial price will then be decided for these shares based on the company’s valuation, assets, demand for shares and a range of other factors. The company then issues the new shares which are then listed on a stock exchange. The shares can be bought or sold during normal market hours and the price of the shares can rise and fall.

Companies can choose which exchange to list on, such as the New York Stock Exchange (NYSE), or London Stock Exchange (LSE). The company will need to meet the specific requirements of each exchange and financial regulators, but which exchange they choose is down to different factors which could suit the business better. For example, accounting standards, listing costs and type of exchange.

Why do companies go public?

An IPO is an opportunity for the company to open itself up to investors and raise new capital. The range of this capital can be vast, for example Facebook went public in 2012 and raised over $16bn. Companies are then able to use this capital to invest in themselves with the aim of accelerating further growth. Companies can choose to go public at different stages of development, and how much they raise can depend on their goals, demand for shares and the valuation of the company.

However, it is not always established companies which go public. In specific circumstances, some companies with strong business fundamentals can qualify for an IPO. This is common in the pharmaceutical industry, where product development to realisation can have longer timelines. For example, one biotech company went public in 2021 and raised $587.5mn despite having no physical product at the time.

What’s in it for investors?

Not all of the benefits of an IPO are exclusive to the company. For investors it often provides opportunities that are hard to find in other investments.

Entering at the 'Ground Floor'

• Entering at ground level may provide opportunity to get in before it becomes popular. By investing in a company when they first go public, there is potential to invest while the share price is lower than you feel it could become as the company grows. This ‘potential’ is one of the factors investors take into account when buying shares in an IPO.

Long Term

• It is said when companies go public, they are entering the beginning of their second life cycle. Investing in its IPO means you can be part of that journey. Investing for the long term not only gives you the opportunity to benefit from potential share price increases, but you could also receive dividend payments and other benefits linked to being a long-term shareholder.

Access to companies you know

• IPOs sometimes involve well-known, popular and exciting companies, which show great potential. It may enable you to invest in companies you like, use on a daily basis or share similar values to. There’s no better evaluation of a company than personal experience.

What are the risks of IPOs?

IPOs are not a guaranteed golden ticket to success. Many companies go public and fall short of expectations.

Investing in IPOs and individual companies isn’t right for everyone. It’s a higher-risk way to invest your money. The value of your investment depends on the fate of that company. If it fails, you risk losing your whole investment.

You shouldn’t invest in an IPO simply because it is gaining positive attention. Volatility is a significant risk that investors need to be aware of. During the first few weeks of trading, the excitement around an IPO can lead to vast speculation, causing price swings both up and down. These swings may not be a representation of the true value of the company.