What Is an IPO? Its Pros and Cons

How IPOs Can Hurt (or Help) You

IPO for twitter
••• The company's owners usually ring the bell at the NYSE when the IPO is launched. Mario Tama/Getty Images

An IPO is short for an initial public offering. It is when a company initially offers shares of stocks to the public. It's also called "going public." An IPO is the first time the owners of the company give up part of their ownership to stockholders.

Advantages 

The IPO is an exciting time for a company. It means it has become successful enough to require a lot more capital to continue to grow. It's often the only way for the company to get enough cash to fund a massive expansion.

For the owners, it's finally time to cash in on all their hard work. They usually award themselves a significant percentage of the initial shares of stock. They stand to make millions the day the company goes public.

For investors, it's called getting in on "the ground floor." That's because IPO shares often skyrocket in value when they are first made available on the stock market.

The IPO also allows the company to attract top talent because it can offer stock options. It can pay its executives fairly low wages up front because of its promises that execs can cash out later with the IPO.

Disadvantages

The IPO process requires a lot of work. It can distract the company leaders from their business. That can hurt profits. They also must hire an investment bank, such as Goldman Sachs or Morgan Stanley. These investment firms are tasked with guiding the company as it goes through the complexities of the IPO process.

Not surprisingly, these firms charge a hefty fee.

Second, the business owners may not be able to take many shares for themselves. In some cases, the original investors might require them to put all the money back into the company. Even if they take their shares, they may not be able to sell them for years.

That's because they could hurt the stock price if they start selling large blocks and investors would see it as a lack of confidence in the business.

Third, business owners could lose ownership control of the business because the Board of Directors has the power to fire them.

Fourth, a public company faces intense scrutiny from regulators including the Securities and Exchange Commission and adherence to the Sarbanes-Oxley Act. A lot of details about the company's business and its owners become public and that could give valuable information to competitors. 

What IPOs Mean to the Economy

The number of IPOs being issued is usually a sign of the stock market's (and economy's) health. During a recession, IPOs drop because it's not worth the hassle when share prices are depressed. When IPOs increase, it usually means the economy is getting back on its feet again.

The IPO Process

The first step is to put together the IPO team. This consists of the investment banker, lawyers, accountants, investor relations specialists, public relations professionals, and SEC experts.

The team's first task is to put together the financial information required. That includes identifying, then selling or writing off, unprofitable assets.

The team must find areas where cash flow can be beefed up. Some companies also look for new management and a new board of directors to run the new public company

A few months before the IPO launch, the company puts together the prospectus and circulates it for comments. The prospectus includes a three-year history of financial statements. After that, the company writes transition contracts for vendors and must complete financial statements for submission to auditors.

Three months before the IPO, the board meets and reviews the audit. The company joins the stock exchange that lists its IPO.

In the final month, the company files its prospectus with the SEC and issues a press release announcing the availability of shares to the public.