What Is an IPO? Its Pros and Cons

How IPOs Can Hurt You

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

Definition: An IPO is short for an initial public offering. Like the name says, it's 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 that ownership to stockholders.

Advantages of an IPO for the Company

The IPO is an exciting time for a company because it means it has become successful enough to require much 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 stock, and so stand to make millions the day it goes public.

The IPO may also allow the company to attract top talent because they can offer stock options. They can initially pay these executives little or no wages with the promise they can cash out with the IPO later.

Disadvantages of an IPO to the Company

Unfortunately, the IPO process requires a lot of work. It can distract the company leaders from their business, which can hurt profits. They also must hire an investment bank, such as Goldman Sachs or Morgan Stanley, to help them go through the complexities of the process. That's expensive.

Second, the business owners may not be able to take many shares for themselves. Instead, their original investors might require them to put all the money back into the enterprise.

Furthermore, even if they take the shares, they make not be able to sell the stock for years if at all. Even when that's not the case, they could hurt the stock price if they start selling large blocks. Investors would see it as a lack of confidence on their parts. Third, they could lose ownership control of their business.

Fourth, a public company faces intense scrutiny from the SEC, the Sarbanes-Oxley Act, and shareholders. Many details of the company's business and its owners become public. That could give valuable information to competitors. (Source: Inc, How to Prepare for IPO, February 1, 2010)

Advantages of an IPO to Investors

The IPO is also an exciting time because the initial shares of stock are usually only available to those who know about it. Many investors prefer to get in "on the ground floor." That's because IPO shares can often skyrocket in value when they are first sold on the stock market.

Disadvantages of an IPO to Investors

There is usually a clause that restricts IPO investors from selling for the first 30 days. That's frustrating when an IPO's value skyrockets, only to plummet to earth a few days later. 

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 if share prices are depressed. When IPOs increase, it usually means the economy is getting back on its feet again.

What Is the IPO Process?

The IPO will take about a year, and cost more than $2 million in fees and other expenses.

Most companies designate a staff person to be the project manager. The next step is to put together the IPO team, consisting of the investment banker, lawyers, accountant and SEC expert.

The first task for the team 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 newly public company.

Around 8-10 months before the IPO launches, companies put together the prospectus and circulate it for comments. The prospectus includes a three-year history of financial statements.

Six months out, transition contracts for vendors must be written. Next, financial statements are completed and submitted for auditing.

Three months before the IPO, the board meets and reviews the audit. The company joins the stock exchange that lists its IPO. In the last month, the company files its prospectus with the SEC, issues the press release and sells the stock.

Besides the upfront fees, companies pay around $500,000 a year in accounting and insurance fees just for being a public company. For more detailed information, see these sources: Matt H. Evans, CPA, CMA, CFM Creating Value through Excellence in Financial Management, The IPO Process; Inc, How to Prepare for IPO, February 1, 2010.