IPO 101: What is IPO? Definition of IPO

IPO means initial public offering – the process by which a company begins selling stock to the public. Companies are considered private entities with a few early investors (i.e. founders, professional investors within the sector) before the IPO. And the individual or institutional investors who haven’t bought shares of the company in the early days but interested afterward compose the public. The public can not invest in the company until it offers stock for sale. Approaching the shareholders of a private company for investment is possible but no shareholder is obliged to sell anything. And if a company sells a portion of its share to the public for the stock exchange, it becomes a public company. IPO is referred to as “going public”.

When a privately held company goes public, it loses some advantages that belong to private companies. Owners of private companies don’t have the obligation of sharing info on the company’s finances or accounting. Founding a private company is relatively easy in the United States and a big portion of the businesses that are small to the medium are private. Mars Candy, Hallmark Cards, Publix Supermarkets, and IKEA are all privately held companies.

With a massive amount of shareholders, the regulations and regulations for public companies are tougher. They’re obliged to form a board of directors and the boards have to release quarterly reports on the company’s finances and accounting. Securities and Exchange Commission (SEC) is the authority where the companies report to in the United States. Similar bodies oversee public companies in other countries. Public companies also abide by the regulations and requirements set forth by their stock exchanges. Major stock exchanges bring prestige to the company. To begin the IPO process, strong fundamentals and potential of profitability are the most important conditions for a private company. Getting listed was difficult and required hard work in the old days but today, because of the fierce competition between stock exchanges, listing requirements are relatively relaxed.

Why Going Public through IPO?

What is the benefit of going public then? A great deal of money and the potential growth that brings. Loans, extra investors or being acquired by another company – the options for private companies to raise their capitals. But IPO brings the biggest amount of money to the company and its early investors by far. Here the IPO numbers of some of the biggest companies of our time:

  • Alibaba Group (BABA) have raised $25 billion in 2014
  • American Insurance Group (AIG) have raised $20.5 billion in 2006
  • VISA (V have raised $19.7 billion in 2008
  • General Motors (GM) have raised $18.15 billion in 2010
  • Facebook (FB) have raised $16.01 billion in 2012

Lots of financial doors open for a publicly traded company. It’s mainly because of the increased inspections and examinations from analysts and investors. It’s a fact that public companies get lower interest rates for debts in general. Public companies can also issue more stock in secondary offerings if there is demand from the market. Since stock can be issued as a part of possible deals, acquisitions and mergers are easier for public companies.

Liquidity is the most important aspect of trading for an investor. The shareholder who has the stock of a privately owned company finds selling shares very difficult – and value is even more difficult. However, the stock market means known price and transaction data as well as ready buyers and sellers. Investors in the stock market buy and sells stock from other public investors, not the company itself, therefore the stock market is referred to as the secondary market. For a company which has access to public markets and the liquidity that brings, attracting top talents is also a major benefit with employee stock ownership plans (ESOPs).

Pros and Cons of IPO process

Pros:

  • Massive amount of investors for raising capital
  • Decreases the cost of capital for the company
  • Increased profits because of the improvements on prestige and public image
  • Attracting better employees with liquid equity participation options
  • Easier acquisitions (possibly in return for shares of stock)
  • Raising more money than the other options

Cons:

  • Sharing information on finances, accounting and tax is required
  • Ongoing legal, accounting and marketing costs
  • The requirement of time and effort for reporting
  • If the market doesn’t accept the IPO price, the stock price goes lower after the offering
  • Creating advantages for competitors with publicly shared information
  • Decreased control, more agency difficulties because of the new shareholders who have voting rights to control the management decisions through the board of directors
  • Bigger legal or regulatory risks (i.e. lawsuits by private securities, some shareholder actions)

A company which can convince investors to buy its stocks can raise a large sum of capital. IPO is generally considered as an exit strategy for the founders and early investors to turn their risk-taking into profit.

The stock market is called the “secondary market” because the traders in the stock market buy and sell stock from other public investors. After the IPO, the stock isn’t bought from the company itself. Companies issue stock to shareholders directly only before the IPO. When someone, a public investor, buys shares of a company, s/he doesn’t hand the money to the corporation. The money goes to whoever sold the shares to that public investor. Even after the company sells a portion of its shares to the public, the company and its owners can keep a significant portion of the total stock. That situation makes the early investors and founders can keep their influence on the company’s action even though there are a big amount of new shareholders.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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