You may have heard about the hype surrounding an IPO, but what is an IPO and how does it work? We’ve put together a primer so you can make the right decision for you when it comes to considering investing in IPOs.
But first, what is an initial public offering (IPO)?
An IPO, or initial public offering, is when a company moves from private ownership (owned by their founders, early financial backers and employees) to one with shares listed on a share market for anyone to buy (and sell). It’s often called ‘going public’.
How does buying an IPO work?
When a company kicks off the IPO process, they create new shares, and each one represents a slice of the business that someone can own. The company then sells these shares to a select group of investors to raise money. This is sometimes called a pre-IPO, but is more typically called an IPO leading up to when a company goes public. The pre-IPO and IPO process can take anywhere between a few weeks to a month, and at completion, shares usually become available on a share market for everyday investors to buy and sell. Some pre-IPOs occur long before a company IPOs, and is completed entirely as a private company. Pre-IPOs do not necessarily mean that the company will ever ‘go public’ and list on the share markets for everyone to buy.
That level of IPO exclusivity feel unfair? It kind of is.
Shares can have the potential to increase in value over time. So generally, the earlier you invest in a company, the more potential those shares have to increase in value. This is because companies have the potential to grow in value as they deliver on their plans (and it takes time for a business to grow!).
Unfortunately, buying shares at the exclusive IPO price before they hit a share market isn’t as simple as you’d hope. Access to these coveted shares is rare! Thankfully, there’s increasing pressure on the financial industry (aka Wall Street) to democratise the IPO process and give everyday investors like you early access to companies before making their public debuts on the share markets.
Why do companies go public?
One of the main reasons a company goes public in an initial public offering is to raise money to achieve their growth goals. But it comes with other advantages too. By going public, early investors, like founders and employees who are part-owners in the business, can sell some of their shares in the hopes of getting a monetary reward for their hard work and initial investment. It can also help boost star power that often comes with going public, generating noise in the media and making their products known to a new group of potential customers.
How do companies go public?
The process of going public involves a fair amount of complexity and people resource for businesses.
When a company wants to go public on the US share markets, it first files a Form S-1 document and a company prospectus with the US Securities and Exchange Commission (SEC). In it they lay out their ownership structure, financials, future plans and any potential risks with investing in the company.
The company then hires an underwriter, an investment bank like JP Morgan or Morgan Stanley (no, ‘Morgan’ is not required to be in an investment bank’s name). The underwriter takes the company on a roadshow where its leadership team pitches their business to drum up investor interest. Institutional investors generally attend these - think big investors like Goldman Sachs, hedge funds and the mega-wealthy. Because of the strict laws surrounding IPOs, you’ll probably never hear about these private events or hear much at all from the company going through the IPO. This lack of publicity is to stop companies from using hype to artificially boost their share price.
Who can invest in an IPO?
As the roadshow progresses, the company and underwriters work together to set an indicative price range for the IPO share price based on interest from institutional investors. Once the indicative price range is set, investors who are able to participate in the IPO can place a request to buy shares before everyone else, that is the public.
How does buying an IPO work?
The night before public trading on the share market is due to start, a block of shares is sold to these IPO investors at a set price, which is called the offering price. This enables the company to make money before their shares are publicly listed, and means the first IPO investors can immediately sell their shares on the share markets.
It’s important to note that while IPO investors may be able to sell their shares immediately, it’s widely discouraged. Flooding the market with shares in a newly IPO’d company can cause the company’s share price to plummet, which can be bad news for the company. Investment banks have been known to exclude institutions from future IPOs if they sell shares too soon, and everyday investors should always think long-term with their investments.
What does it mean to invest in an IPO?
An IPO, or initial public offering, is the entire end-to-end process of taking a company public. Investors have two opportunities to invest in IPOs:
- During the IPO: exclusive access to request to buy shares before they are listed on a share market.
- After the IPO: buy shares as soon as they’re listed on a share market.
Any investor who gets the opportunity to invest in an IPO can place a request to buy shares at the offering price, which can be lower than the opening price when shares start trading publicly. Investors who buy shares in an IPO already own them before the company is listed on a share market, so they can sell their shares (and buy more) on the share markets when they go public.
IPO pros and cons
What are potential benefits of investing in IPOs?
For most investors, a benefit of investing in an IPO is being first with the opportunity to invest in a company. This is when the shares are sometimes at their lowest price. Take Amazon as just one example of many. IPO shares at the offering price in 1997 would have cost US$18 a share (they made their public debut to everyday investors at US$18). Fast forward to 2021 and a share in Amazon was valued at over US$2,000 pre stock-split.
What are the potential risks of investing in an IPO?
Yes, there are potential risks to be aware of. During an IPO, you're buying a slice of a company before they’ve had a chance to hit the share markets where everyone can buy shares. The IPO share price is set based on the views of a handful of institutional investors. But when shares are listed on the share markets, every investor in the world can make their opinion felt by buying or not buying shares in the newly listed company. A kind of public seal of approval, if you like. A company's share price is driven by market supply and demand, and until they start to trade, no one will know if there's low or high demand for shares in the newly listed company.
Are IPOs a good investment?
It can be difficult for anyone to predict a company’s share price on their first day of trading (without a crystal ball) or even the months following. This is because there's often little publicly available historical data to analyse the company’s performance. Most IPOs are done by companies going through growth periods (which is often why many are raising money through an IPO in the first place!), and there can be uncertainty about their future value.
There are plenty of IPO examples where companies traded below their opening IPO price. While IPOs can be exciting, the same long term investing principles apply. Research a company before you invest, and seek financial advice if you’re unsure about your personal situation.
While a company’s prospectus can make for intense night time reading (some coming in at around 200+ pages!), it can help to understand potential risks. And it’s always wise to do your research before committing your hard-earned money to an IPO.