What Is an IPO? How Initial Public Offerings Work

An initial public offering (IPO) is the first time a private company sells shares to the public and lists them on a stock exchange such as the NYSE or Nasdaq. IPOs often attract lots of attention, but they can be among the riskiest stocks to buy.

Why companies go public

• To raise money for growth, research or paying down debt.
• To let founders, employees and early investors sell some of their shares.
• To gain a public share price that can be used for acquisitions and employee pay.

In exchange, the company must publish detailed financial results every quarter and face scrutiny from investors and regulators.

How the process works

1. Hiring underwriters: investment banks guide the process and help sell the shares.
2. Filing with the SEC: the company publishes a registration statement, including a prospectus with its financials, business details and risks. This is the best source of information about the company.
3. The roadshow: management pitches large investors, and the banks gauge demand.
4. Pricing: the night before trading starts, the IPO price is set and shares are allocated, mostly to large institutions.
5. First day of trading: the stock opens on the exchange, often at a different price from the IPO price.

The first-day pop

Many IPOs jump on their first day, because banks often price shares a little below expected demand. Most individual investors can't buy at the IPO price, though; they buy once trading starts, often after much of the pop has happened. Some brokers now offer limited access to IPO shares, but allocations are usually small.

Lock-up periods

Insiders and early investors typically agree not to sell their shares for a set period after the IPO, often 90 to 180 days. When the lock-up expires, a wave of selling can push the price down.

Risks of buying IPOs

• Limited history: there are fewer years of public financial data to judge.
• Volatility: new stocks often swing wildly as the market settles on a price.
• Hype: media attention can push prices well above what the business supports.
• Insider selling after lock-ups expire.
• Losses: many companies go public before they're profitable.

A careful approach

Read the prospectus, focusing on revenue growth, margins, cash burn and the risk factors. Consider waiting for one or two quarterly reports and the lock-up expiry before buying. Apply the same stock analysis checklist you'd use for any company, keep the position small, and see market cap to judge how the valuation compares with established peers.

This article is educational and not investment advice.