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What is an IPO?

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Try imagining a business owner. Maybe you think of the owner of a small business, like a hair salon or a roadside kiosk. Or maybe you think of a billionaire entrepreneur. You probably don’t think of the tens of millions of people who own small shares of publicly traded companies, but they are business owners, too. Each share they own is a tiny fraction of a large company, which anyone can buy and sell on a stock exchange. Companies whose shares are traded on these exchanges are called publicly traded companies. Private companies, on the other hand, are those held by people we typically think of as business owners–a single person or small group of people who founded, manage, or invest in the business. 

What is a private company? 

Most private companies are small and medium-sized businesses. They include the aforementioned hair salon and kiosk, as well as restaurants, construction companies, dry cleaners, and a variety of other businesses. A few of the world’s largest companies are also privately held, although they are the exception. You may have heard of some of them: Huawei, IKEA, Mars, and ByteDance (the company behind TikTok) are all private companies, for example. 

What is a public company?

Most of the world’s largest companies are not owned by their founders or CEOs, but are divided into millions or even billions of tiny parts owned by investors. Take Amazon, for example. There are currently 10.17 billion shares of Amazon stock, held by approximately 7,000 investors. The vast majority of these shares are owned by retail investors, or regular individuals who invest in the stock market. This is a bit unusual. Globally, about 41% of all stocks are owned by institutional investors, meaning organizations like banks, hedge funds, and mutual funds that invest larger amounts of money. 

Why would a company go public?

An initial public offering, or IPO, is the process of a company “going public” – that is, transforming from a private company to a public one. There are several advantages for companies in going public. 

#1 Growth: Companies need money to grow, and an IPO is an attractive way to raise money. Shareholders pay the company in exchange for partial ownership, and the company can then use that money to grow. 

#2 Cashing out: Before the IPO, the founders and early investors own pieces of the company, but they can’t readily sell those shares. An IPO is an opportunity for these early shareholders to convert their previously illiquid shares into cash. 

#3 Public Awareness: Another benefit is increased media exposure for the company. News agencies pay more attention to public companies, and this increased attention can help the company sell its product. 

What do IPOs mean for companies? 

Regulation and disclosure: Public companies are subject to more intensive government regulations. Unlike private companies, they must make regular public disclosures of their financial information. Complying with these regulations can cost the company millions of dollars per year. 

Shareholders in charge: Public companies are accountable to their shareholders. The company’s management must keep shareholders happy, because the shareholders are the ones with the power to hire and fire company leaders. 

How do companies price and list their stocks? 

A company going public usually starts by hiring one or more investment banks to help them structure the whole process and decide on the initial price of their shares. Along with the investment bank, the company issues a prospectus and a public subscription notice (PSN) detailing its business model and plans for the funds raised. They sell the shares in two stages–first to institutional investors, and then on the open market. 

The first stage is selling the majority of the shares to institutional investors. Institutional investors include large companies like hedge funds, mutual funds, and pension funds, as well as wealthy individuals. These institutional investors get to buy the stock at the IPO price–a special rate not available to most individual investors. The company and investment bank set the IPO price based on the price investors are willing to pay per share, and the regulator approves this price. 

Next, the company and its bank make the shares available to the general public. They decide on a subscription period, during which individual investors submit orders for the shares. Based on these orders, the stock exchange sets the opening price for the stock. This is the price at which the stock begins trading on the stock market. At this point, the stock is now available for anyone to buy and sell.                                         

What happens to the stock price after an IPO?

IPOs tend to be hot on the first day of trading. The high return from this first day–on average about 20% – is known as the “IPO pop”. But the IPO pop is a short-term phenomenon. Once a few years have passed, most IPOs underperform relative to the market. In fact, after three years, approximately two-thirds of IPOs have negative returns – meaning that the price of the stock has decreased from its opening price. However, the third with positive returns significantly outperforms the market.

What do IPOs mean for me as an investor?

Is it worth it to invest in IPOs? It all depends on your risk preference. On the one hand, an IPO may be your opportunity to buy shares of a promising company at a low price. When the stock price rises, your investment will grow. In two out of three cases, however, IPO shares will decrease in value. It can be hard to predict which IPOs will succeed and which will fail, because newly public companies don’t have a track record on the stock market. If you do buy IPO shares, make them part of a well-rounded portfolio. A diversified portfolio can provide a safety net so you can take calculated risks, like investing in the IPO of a company that you believe in.