The first time a private company puts its shares up for sales to everyday investors is called an initial public offering (IPO). It’s commonly called “going public.”

The new public shares are listed on one of the common exchanges, like NASDAQ or New York Stock Exchange (NYSE). IPOs are a common way for private companies of all sizes to raise capital that it otherwise wouldn’t have access to.

There are hundreds of IPOs that happen each year, and some IPOs of well-known companies like Google and Facebook garner much attention from the media and the public alike.

How Does an IPO Work?

Going through the process of the initial public offering is a laborious, time consuming ordeal that is a challenge for companies to go through without help. There are additional files of paperwork after going public and also for the additional financial disclosures that are required for a public company. These regulations are required by the Securities and Exchange Commission (SEC), the governmental body that maintains and regulates such disclosures.

This additional work is why private companies often hires an underwriter to assist with the proces of the initial public offering. The underwriter is usually an investment bank and they help navigate the rules and regulations associated with the IPO process. The investment banks assist with the financial auditing, the initial disclosure documents, and the process of gaining initial shares and making sure the IPO is successful.

The investment banks help sell early shares of the companies to their own clients, often institutional banks and other private clients. This early distribution of the shares is part of the process in making sure that the initial public offering is a success when the shares are available to the public.

The underwriters also help the company determine an initial price for the IPO shares when they begin publicly trading on the stock exchange that they are listed.

Why Do an IPO?

There are several reasons why a private company might do an initial public offering.

One of the main reasons is that an IPO allows the compain to raise capital at levels that aren’t available by other means. Since the IPO is likely the first time that the everyday consumers can purchase company shares, the volume of money coming into the company can be larger than other mechanisms.

Companies can raise additional capital by selling shares to the public. The proceeds may be used to expand the business, fund research and development or pay off debt. Other avenues for raising capital, via venture capitalists, private investors or bank loans, may be too expensive.

One way to think about the IPO is to think of the company growth in stages. The private growth stage is one stage and going public with an IPO is the start of a second stage. It’s the start of a new version of it’s growth stage.

When going public, this is a time to let early-stage investors to cash out. In some companies there is a lot of private money that is put into the private company before it goes public. This is way for the original investors to cash out or sell all or a portion of their stake in the early start-up. Further, when mature companies go public, it allows the private investors to sell some of their shares in the general market.

Besides this, there are other reasons for a company to go public. One reason is to raise the profile of the company in the public. Going public in an IPO can provide companies with a huge amount of publicity.

Companies also enjoy the [gravitas] that is associated with being employed by a public company. Further, it may be easier for a public company to get better terms from banks and other lenders.

There are downsides also. There are disclosure requirements, such as filing quarterly and annual financial reports. They must answer to shareholders, and there are reporting requirements for things like stock trading by senior executives or other moves, like selling assets or considering acquisitions.

We’ll go into more detail for each of these in the next section.

Key Reasons For Purpose of IPO

New Sources of Capital – Going through the IPO process allows a company to raise money in ways that aren’t available in other ways. In competitive environments, having access to greater amounts of funding is a significant advantage when competing against other firms. The money raised from going public can be used to expand operation, acquire new customers, add new services, and even pursue additional mergers and/or acquisitions. Even with the additional cost of the IPO process, the cost is lower than other forms of raising capital, like using debt to finance future growth.

Raises Awareness of the Company – The public profile of a company is raised after a company goes public. In many situations, a company that is public has greater recognition than other firms that are private. Public companies hold a special perception from investors and consumers when compared to other firms.

Sell Existing Shares – When a company goes public, it allows existing shareholders to cash out some of their shares. This reason isn’t often reported to everyday investors, but it is an important motivation for early investors. Going public allows existing company shareholders to sell some of their existing stock and to do it at premium prices. Many early investors dream of getting in early on a private company and then “cashing out” for a big win when the company has a successful IPO. And even if early investors don’t cash out, there is a certain type of bragging rights that exists amoung investors who remain involved in the company after the IPO.

Retaining Key Employees – A key employee is defined as one who is indepensible to the operation of the company. These employees are asked to stay on to help with the accelerated growth of the company after it goes public. These employees often are awarded options of shares as part of their compensation package. The terms of these options vary, but these employees are often allowed to sell some of their shares at some point in the future between one and five years after the company goes public. These options are provided as an incentive for the employees to continue their employment with the company.

Create A Diverse Investor Base – By going public, investors have an easy way to enter and exit the company. This ease of entry is important for investors who are more short-term oriented, and they may be interested in buying and selling shares on a shorter time frame than other, longer-term investors.

IPO Alternatives

There are two main alternatives to an initial public offering.

One is called a direct listing. A direct listing is the process of going public, but it is performed with the assistance of an underwriter. In this sitution, the shares of the company are offered directly to the public. By skipping the underwriting steps, the company carries more risk since there’s some change the initial offering might not perform well. On the other hand, a company will benefit more if the share price does go higher. In direct listings, the process is usually only successful to companies with large awareness and name recognition, and in a market that is perceived to be expanding and growing.

The other alternative to an IPO is called a Dutch Auction. In a Dutch auction, the initial price is not pre-determined, but rather is determined by a unique bidding process. This auction is unique in that the buyers of the shares make a bid for a number of shares and the price they are willing to pay.

After all bids are received, the shares are given to individual bidders starting from the highest bid then moving down until the allocated shares are all assigned. However, the top bidder is not forced to pay their price, but instead is only asked to pay the lowest price of the pool of allocated bidders.

Investing in an IPO

There are several things for the company to consdier before going through the IPO process.

Because of the process is costly and time-consuming, a company consdiering an IPO to raise capittal must go through careful analysis. The management team must determine if the process will maximize the returns of the early investors, as well as provide the company with the funds that it needs to continue to grow. The management team must also determine how to raise the most money for the business through the IPO.

That’s why if an IPO decision has been approved, the potential for future growth is high. And it’s this evaluation that leads to many everyday investors wanting to get a piece of this new companies shares that are available through the IPO.

With the use of an underwriter, the company sets the IPO price in their “pre-IPO”process. The price is based on standard valuation models and calculations using fundamental financial techniques. For example, you’ll often see common calculations of DCF discounted cash flow, which is the net present value of the company’s expected future cash flows. Other methods that may be used for setting the price include equity value, enterprise value, comparable firm adjustments, and more. The underwriters do factor in demand but they also typically discount the price to ensure success on the IPO day.

Because the private company has little history and only a limited track record of performance, it can be difficult for analysts to find a reasonable valuation of the company before the shares are issued. Whatever final analysis is performed, the details are provided to the public free of charge through the filing of a S-1 Registration.

This filing provides a lot of useful information. Investors should analyze this document carefully, as it will provide information on the industry, the future trends, the management team and their vision for the future. The filing will also list relevant details about the specifics of the issuance.

The underwrites will take the shares of the private company and offer them for sale to large private accredited investors and institutional investors. These shares are often sold at a discount, but sold in large quantities. The share price of IPOs is discounted to guarantee a certain volume of sales and to make sure there will be success on opening day. The success in this stage provides a large influence on the performance of the IPO on opening day.

The public investors don’t become involved in the buying and selling until the opening day. On opening day, any investor with a trading account can buy and sell shares of the IPO.

Generally, the IPO process is complex one. But in the end, with proper analysis and diligence from both the company and the individual investor, there can be a win-win situation for both parties.

Is an IPO a Good Investment?

Because of the growing interest in IPOs over the last several decades, IPOs often attract more than their fair share of attention from the media as well as the interested investor.

Overall, IPOs have developed a reputation for produce large returns for the early investors. While this is true in some cases, there are plenty of situations where the IPO performance did not live up to it’s expectations.

In other words, for every high profile IPO that has ‘hit it big,’ there are other IPOs that sunk in their performance.

There are many factors that determine the success of an IPO. Before you invest, you should perform your own due diligence and analysis of the company, its prospectus, and the future growth potential of the company.

Final Words About IPOs and Investing

Investing in a newly public company can be financially rewarding.

Private companies regularly go public, and there are plenty of stories about successful investors who bought shares of an IPO and saw them skyrocket. Yet, not every IPO is a winner.

To make sure that you have the best chance of success, be sure to review all the materials available to you before you invest.

When investing new, unproven companies going through an IPO, an informed investor making a well-reasoned decision will do better over the long term than investors eager to jump on board without proper research.