IPO (Initial Public Offering) Definition

How IPOs Are Created and an IPO Example

GoDaddy IPO on the New York Stock Exchange (NYSE)
Spencer Platt / Staff / Getty Images

Definition:

IPO stands for Initial Public Offering. Referred to as taking a company public, the IPO involves a private company offering its shares to the public for purchase for the first time. Thereafter the shares become listed on a stock exchange and trade in the open market.

Why Do Companies Go Public With an IPO?

IPOs are typically used by newer companies who need additional capital to expand or by privately owned companies whose owners and investors wish to monetize their original investments (see exit strategy).

If market conditions are right for the particular business at the time of the IPO, the original investors in the private company can make fortunes because the new stock is worth much more than their initial investments.

How Is an IPO Created?

Normally a private company that wishes to go public via an IPO on Wall Street does so by having investment bank (such as Goldman Sachs or Morgan Stanley) underwrite the share issue. Through negotiations the company and the investment bank decide on how many shares will be issued, the type of shares, and the issue share price. Depending on the agreement, the underwriter may guarantee the amount raised by purchasing some or all of the shares and then reselling them to the public.

The investment bank prepares the IPO by submitting registration information to the Securities and Exchange Commission (SEC), including details of the share offering, financial statements, management information, etc.

The SEC performs background checks on the registration to make sure all the correct information has been disclosed in the submission.

After SEC approval the company and the underwriter begin marketing the issue to customers by issuing a series of prospectuses which describe the company and the share offering (see Zipcar prospectus for an example).

At first the shares are typically offered to larger institutional investors such as pension funds, life insurers, mutual funds, etc. who can afford to purchase large blocks of shares (usually at a discounted price). Eventually the shares are listed on a stock exchange and can be purchased by individual investors.

Example of an IPO

In the tech world the biggest IPO ever (and the biggest in internet history) was that of Facebook on May 18, 2012. Founder and principle shareholder Mark Zuckerberg had resisted taking the company public for years, instead raising capital by private sales of shares to other companies such as Microsoft. At the time of the IPO Facebook had over 500 private shareholders and over 800 million monthly users.

A few months prior to the IPO, Facebook was intending to price the IPO shares at $28 to $35 per share. However, due to anticipated high demand the number of shares to be sold was increased by 25% and the IPO price per share was raised to $38, giving Facebook a peak market capitalization of over $104 billion dollars.

Unfortunately the price of the stock fell on opening day and continued to fall for the next two months, dropping below $20 per share in August 2012.

The shares did not recover to trade above the IPO price for over a year after the IPO.

IPOs Are Not Always a Success

While an IPO can be financially advantageous for business owners, success is certainly not guaranteed and there are several drawbacks. First, you may not be able to get your money out as fast as you would like. Investors may insist that all the money raised by the IPO be reinvested in the business. And a portion of your shares could be held in escrow for years.

Second, your ownership position may be seriously whittled down and you may lose control of the company. To avoid this owners who wish to retain control of a company after an IPO can do so by issuing separate classes of shares that carry different multiples of the voting weight.

In the Facebook example above Mark Zuckerberg owned only 18 percent of the company after the IPO.

 However, the public IPO issued (Class A) shares had 1/10th of the voting weight of the original private (Class B) shares. His quantity of Class B shares amounted to 57 percent of the voting shares and left him in control of the company after the IPO.

From an investor perspective IPOs can be a risky investment. Without historical information it can be difficult to properly assess the share value of a company, and IPOs tend to be issued when market conditions are favorable. IPOs such as Webvan and pets.com that were launched during the dot-com bubble turned into spectacular failures when the bubble burst and both companies eventually went bankrupt.

See also:

6 Exit Strategies for Your Small Business

How to Attract Angel Investors

3 Ways to Find What Your Small Business is Really Worth