What Is an Initial Public Offering (IPO)?

IPOs Explained in Less Than Five Minutes

An IPO, or initial public offering, refers to the process a private company participates in as it offers shares of stock to investors for the first time. When a company goes through an IPO, we often say it is “going public.” 

Learn the ins and outs of the IPO process, what a company needs to do as it prepares to go public, and what IPOs mean for individual investors. 

Definition and Examples of an Initial Public Offering (IPO)

When a company wishes to move from private to public ownership, it undertakes an IPO.

The IPO process allows a company to raise money to fund operations, fuel growth, and pay down debt. An IPO also gives companies the opportunity to pay back its investors, who have the option of selling their private shares into the IPO. Generally speaking, a private company with considerable growth potential will consider going public, primarily for the reasons mentioned earlier. In many ways, it’s the logical and expected next step for successful startups. 

One of the more high-profile, recent examples of a company going public is the story of Airbnb, which went public in the winter of 2020. Airbnb’s IPO prospectus will serve as a guide throughout the following sections, which detail how an IPO functions and what recent public companies mean for individual investors. 

How an IPO Works

To go public, a private company must register its IPO with the U.S. Securities and Exchange Commission (SEC). Companies typically use Form S-1 to register with the SEC. Within that S-1, you’ll find the company’s IPO prospectus, which spells out the details of the IPO process. It’s a crucial document investors must read when considering an investment in a newly public company. 

IPO Terms and Underwriters 

The S-1 lays out the terms of a company’s IPO, particularly focusing on the number of shares it will issue to the public.

As a company prepares to go public, it hires underwriters. These are the financial institutions that receive the shares of the IPO before distributing them to the public. Companies select lead underwriters, who help guide the IPO process and allocate shares. In the case of Airbnb, Morgan Stanley and Goldman Sachs were selected as its lead underwriters.

History, Story, Present Condition, and Risks

Companies use their prospectus to sell potential investors on their IPO. 

As such, the company does a bit of a dance in the IPO prospectus—tooting its own horn and providing a straightforward assessment of challenges it faces and what could go wrong. 

Most S-1 forms look like Airbnb’s, which begins with a look at the company’s history and how it became a viable force in its industry. From there, it outlines the climate the company operates in ahead of its IPO, along with specific financial metrics. 

Form S-1 often marks the first time investors get to see details about revenue, profit, and expenses from a private company.

Here’s an example of how this looks in Airbnb’s prospectus summary: 

In early 2020, as COVID-19 disrupted travel across the world, Airbnb’s business declined significantly. But within two months, our business model started to rebound even with limited international travel, demonstrating its resilience … We believe that the lines between travel and living are blurring, and the global pandemic has accelerated the ability to live anywhere. Our platform has proven adaptable to serve these new ways of traveling … 

We have experienced rapid growth since our founding. In 2019, we generated Gross Booking Value (“GBV”) of $38.0 billion, representing growth of 29% from $29.4 billion in 2018, and revenue of $4.8 billion, representing growth of 32% from $3.7 billion in 2018. During the nine months ended September 30, 2020, our business was materially impacted by the global COVID-19 pandemic, with GBV of $18.0 billion, down 39% year over year and revenue of $2.5 billion, down 32% year over year.

This summary is a great look at what a company must disclose in its S-1. Of course, COVID-19 became a risk for most companies, particularly Airbnb, given that it’s part of the travel industry. 

How Will a Company Use the IPO Proceeds?

The S-1 also includes details on how the company plans to allocate shares to investors, as well as how the company intends to use the capital it receives after going public. 

Here’s part of Airbnb’s description on how it intended to use its IPO proceeds: 

We currently intend to use the net proceeds from this offering for general corporate purposes, including working capital, operating expenses, and capital expenditures. We may also use a portion of the net proceeds to acquire or make investments in businesses, products, offerings, and technologies, although we do not have agreements or commitments for any material acquisitions or investments at this time.

From there, the company provides specifics on its business model, risks it faces, and all of the key metrics it uses to assess its performance. The S-1 gives prospective investors a true look under the hood of a private company as it takes the steps to go public. 

What an IPO Means for the Economy, the Consumer, and the Investor

You may have heard the phrase “hot IPO market.” Generally speaking, this means that the investing public have received companies that go public well. This can cause other private companies to take the plunge into going public. This can also indicate a potentially strong economy, if a significant swath of private companies are doing well enough to increase investors’ appetite for risk

When an IPO does well, it’s often referred to as a “hot IPO.” This means the demand for shares paces ahead of supply, making the IPO more attractive, thus driving its initial offering price higher. Underwriters generally set aside those shares for their most valued and highest net-worth clients. 

As with any investment, some IPOs do better than others. And as a consumer and individual investor, you typically have two options if you want to invest in an IPO. 

If you are an underwriter or client initially involved with the IPO, the chances are high that you will have the opportunity to participate in the IPO. In this case, you will be able to purchase the shares at the offering price. However, with this option, you’re at the mercy of priority and luck to secure shares, so it’s best to not count on investing in an IPO this way. 

For high-demand IPOs, there’s often a significant discrepancy between the offering price and the price the stock opens at on its first day of trading. From there, considerable volatility often follows. 

The other way the individual investor can get in on an IPO is by waiting for the shares to hit the market, and purchasing in the following days after it goes public. In this case, an investor can place an order through their broker to purchase shares. However, there may also be a problem with this. 

Let’s say a company’s stock is priced at $10 before it opens to public trading. You only own those shares at a cost basis of $10 per share if your brokerage allocated shares to you at the offering price. Once the shares hit the market, they often fluctuate wildly, opening at a considerably higher price than the offering price. If your brokerage doesn’t allocate those shares to you at the offering price, and you wait a few days after the IPO to buy shares, you’ll likely pay more.

In Airbnb’s case, the stock opened at $146, much higher than the $68 offering price it set just ahead of its debut. By the end of April 2021, Airbnb traded between $170 and $180 per share.

Not all IPOs perform as well as Airbnb’s did from the start. Some hit highs on the first day they go public, but only see downside from there. Simply put, IPOs can be volatile investments with a high risk level, particularly if you must wait to buy shares until they are on the public market. 

Pros and Cons of IPOs for Investors

Alongside each benefit of investing in an IPO comes a downside for individual investors. 

Pros
    • Potential of acquiring shares at an attractive price
    • High risk, but high potential reward
Cons
    • Likelihood of investing at the IPO’s offering price is low
    • High risk, but high potential reward

Pros Explained

  • Potential of acquiring shares at an attractive price: If you’re able to participate and have access to a hot IPO, you can acquire shares at the offering price. This generally occurs if you are considered an institutional or high-net-worth client. Examples of an involved institution who may be granted this access include mutual funds, pension funds, hedge funds, and insurance companies.
  • High risk, but high potential reward: Particularly with the most sought after IPOs, you can get in early on high-flying companies, such as Airbnb or other IPOs in recent years, like Uber or Lyft. 

Cons Explained

  • Likelihood of investing at the IPO’s offering price is low: Most individual investors will not have the opportunity to purchase shares at the IPO’s offering price. Instead, they’ll have to buy shares once the stock goes public, often at a premium to the offering price. 
  • High risk, but high potential reward: What is a positive can also have a downside. The question remains: Can you acquire shares, either at the offering or on the public market, at an attractive price? IPOs can be volatile investments, with their stock price fluctuating wildly after they go public. 

Tips for Investing in IPOs

Your best best is to consult a financial advisor and take a conservative approach when investing in IPOs. If you’re lucky enough to receive an allocation of shares at an IPO’s offering price, be sure to do the research and due diligence (like reading the prospectus thoroughly) before investing. Remember, an IPO can drop below its offering price after hitting the public market—its price won’t always go up. 

If you plan on buying shares on IPO day or shortly after, treat your investment like any other. Ask yourself, do you believe in the company’s long-term growth prospects and potential for share price appreciation? Are you willing to ride out volatility? Are you confident enough in the company to purchase more shares when the price action sees considerable downside? 

Key Takeaways

  • When a private company such as a startup seeks to raise capital to fund its next phase of growth, it often goes public through an initial public offering, or IPO.
  • A company must register an S-1 form (among other documents) with the SEC detailing its history, story, underwriters, IPO terms, and more. Most importantly for investors, it must spell out a detailed illustration of its challenges, risks, business model, key operating metrics, and current and anticipated financial condition.
  • Companies give shares in its IPO to the underwriters, who then distribute shares to their clients at the IPO’s offering price before the stock trades on the public exchange. 
  • A significant difference often occurs between an IPO’s offering price and what it trades for once it goes public. Sought after, “hot IPOs” best illustrate this discrepancy, which should serve as a note of caution for prospective investors, particularly if you intend to buy shares once the IPO is open to the investing public.