April 15, 2024

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What is an IPO?

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Last Updated on September 25, 2023 by MrHudson

For most traders, an IPO is the first time and opportunity to gain exposure to a publicly traded company’s shares. In this article, we dive deeper into what is an IPO, how an IPO works, the reason why companies want to go public, and key terminologies that investors should know. Make sure to keep reading this guide to learn more.

What is an IPO?

An initial public offering (IPO) refers to the process of a private company offering shares to the public in a new stock issuance for the first time. An IPO allows a company to raise capital from public investors. The transition from a private to a public company can be an important time for private investors. This is because they can fully realise any potential gains from their investments.

Here, the company will decide on how many shares it wants to offer, and an investment bank will then suggest an initial price for the stocks that are based on their predicted demand.

How does an IPO work?

Before an IPO, a company is privately owned, usually by the founders or people close to the founder. In order to go public, a company must then undertake the IPO process. However, going public is incredibly challenging and time-consuming, and the process is difficult for most companies to navigate alone. A private company not only needs to prepare itself for an increase in public scrutiny but also has to file a lot of paperwork and financial disclosure forms in order to meet the requirements of the Securities and Exchange Commission (SEC). This is the organisation that oversees public companies.

In order to go public, most companies will then hire an underwriter, which is usually an investment bank. The underwriter consults on the IPO and helps the company set the initial price for the offering. Underwriters also help the company prepare for an IPO by creating key documents for investors, as well as scheduling meetings with potential investors, otherwise known as roadshows.

Once the company and the underwriter have set an initial price for the IPO, the underwriter will then issue shares to investors. The company’s stock will then start trading on a public stock exchange, such as the NASDAQ or the New York Stock Exchange (NYSE).

Why do companies want to go public?

There are plenty of different reasons as to why a company would want to go public. The reasons will depend on their circumstance. That said, most businesses are looking to raise capital in order to fund their operations, expand, attract and retain talent, pay debts, or monetise their assets. A company may also want to list on a stock exchange to improve its public profile.

That said, while going public may make it easier for companies to raise capital, it can complicate other matters as well. For instance, there are disclosure requirements, such as filing annual and quarterly financial reports. Companies must also answer to shareholders, and there are additional reporting requirements for things such as stock trading by senior executives or other activities, like considering acquisitions or selling assets.

Key IPO terms to know

Like most things related to finance, IPOs and related activities have their own special terminology. Before getting started with an IPO, it is important you understand a few key terms:

  • Issue price: This is the price at which shares of common stocks will be sold to investors before an IPO company starts trading on public exchanges. These are also commonly called the offering price.
  • Common stock: These are units of ownership of a public company. They mainly entitle stockholders to vote on company matters as well as receive company dividends. When going public, a company will offer shares of common stocks for sale.
  • Lot size: This is the smallest size of shares that a person can bid for in an IPO. If investors want to bid more shares, they must first bid in multiples of the lot size.
  • Price band: This refers to the price range at which investors can bid for IPO shares. This is set by the company as well as the underwriter. It is typically different for each category of investor. For instance, qualified institutional buyers may have a different price band when compared to retail investors.
  • Preliminary prospectus: This is a document created by the IPO company that discloses information about its business, historical financial data, its strategy, recent financial results and management. It has a red lettering down the left side of the front cover. This is sometimes called the red herring.
  • Underwriter: This is the investment bank that manages the offering of the issuing company. The underwriter typically determines the issue price, as well as publicises the IPO and assigns shares to investors.

Advantages of an IPO

One of the major advantages of an IPO is that a company can get access to investments from the entire investing public in order to raise capital. This capital can then be used to fund their business operations or expansion. This makes it easier for acquisition deals to be made, as well as increases the company’s exposure, public image and prestige, which can help the company’s profits and sales.

Going public also means companies have to release more financial reports. This increased transparency that comes with quarterly and annual reporting can help a company gain more favourable credit borrowing terms in comparison to a private company.

IPOs can also be beneficial to traders because it is generally easier to buy publicly traded shares through a stock exchange than shares from a private company.

How long is the IPO process

The length of an IPO process can vary depending on how well it is being coordinated and managed. The first stage of the IPO process is the financial audit stage, and it can take the longest, especially if the company’s records and books are not organised.

Sometimes, in order to combat the time taken to facilitate a traditional IPO, some companies are turning to other alternative methods of going public. An example of this would be SPACs, which may be faster than the traditional IPO process.

Bottom line

In order for a private company to go public, it must undertake the IPO process. This is where their shares will be listed on public stock exchanges for the first time. Companies usually go public for many reasons, such as raising capital to fund their operations and expansions, increasing their public image and reputation, attracting new talent, and more. Overall, undertaking an IPO can be a time-consuming process, but also rewarding as well.

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