If you read about startups, are interested in investing, or keep a finger on the pulse of cutting edge tech, you’re probably heard of an IPO. IPOs are a big deal for new companies — but what exactly are they?
IPO stands for initial public offering; it’s when a startup goes from only accepting private investors to being publicly traded on a stock exchange. In this post, we’ll explain some things to know about IPOs, like what they really are, how they work, and how the opening price of an IPO is determined.
We’ll also cover some important information on whether they make good investments, and how to invest in one if you do choose to. Read on for a thorough look at IPOs, or jump ahead to a section that has the information you need.
We’ll start with an explanation of IPO meaning.
What is an initial public offering (IPO)?
An initial public offering (IPO) is the first time that a company goes from only accepting private investors to being publicly traded on a stock exchange. That means that the company joins other large companies that appear in market indexes, and that its shares can be purchased by any investor with the capital and desire to do so.
Before going public, companies are private. This means that only certain investors hold shares of the company, often business partners of the company’s owners. Once the company goes public, shares become available on the market.
How do initial public offerings (IPOs) work?
IPOs convert private companies into public ones, allowing the general public to purchase stock on an exchange like the New York Stock Exchange. New IPOs can be startups that have been set up to grow quickly and then go public, or they can be older companies that had been privately owned before, but are now looking for a new source of investors.
Before a company goes public, it must be underwritten by an investment bank or banks. This process is intended to ensure that the business has a reliable business model, plenty of opportunity for growth, and has its finances in order. Companies must file appropriate forms with the Securities and Exchange Commission (SEC), a branch of the federal government that regulates the financial industry.
At first, larger investors may have a chance to invest in the company. However, after this initial phase of investments, the stock usually goes fully public, and becomes available for purchase by anyone with access to a broker or robo-advisor.
What is a stock? Essentially, it’s part ownership — or a share — in a company’s value. When the company’s total value increases, your slice of the pie increases along with it. However, if the company loses value, your ownership stake shrinks too. That’s why it’s important to remember that, no matter what investment path you choose, there is always some risk involved in every IPO investment.
How is the opening price of an IPO determined?
IPOs don’t all open at the same price. When a company launches its IPO, its stock opens at a certain price per share. But how is that determined? There are a few factors.
Supply & demand
Like almost everything on the market, part of the value of shares of a new IPO is the supply and demand for shares. Heard of supply and demand but not entirely sure how it works? Here’s a quick breakdown.
When there’s a high supply of something, prices tend to be lower. This is because there’s not much competition to get a unit of the product or service — there’s plenty to go around. Think of something like paper towels: they’re cheap and easy to produce, so there are tons of them, so they are cheap. However, when supplies are lower, rarity makes it harder to get your hands on a unit, so prices can go up. Think of something like diamonds: they’re hard to excavate or manufacture, so supply is low, and prices can be much higher.
Demand works oppositely. Tons of people wanting something makes the price go up, as they’re willing to pay more to actually be the one who gets a unit. Low demand means that sellers may have to drop prices to get anyone interested in buying.
When new shares go on the market, they’re affected by the supply and demand as much as anything else. Something highly anticipated, like Uber, might have a massive demand relative to supply, whereas a smaller, lesser-known IPO might have a much lower demand and comparatively higher supply. These factors make the price of high-demand stocks go up.
Company value is also a determining factor in the price of a new IPO’s shares. Companies that possess high revenue, massive assets, and plenty of capital to work with are likely to have a higher stock price. That’s because, with all that value the company possesses, each individual slice of the pie that a shareholder hopes to buy is more valuable.
Remember, buying a security (like a share of company stock) means buying into that company’s total value. Companies that have a huge total value have a higher stock price just because each individual piece of the pie is worth more.
- Fun fact: the highest-valued IPO ever was Ali Baba, the Chinese retail goliath. The company was worth a whopping $25 billion at its IPO.
Future growth prospects
Lastly, a company’s prospects for future growth go into determining the price of each share. Companies that show a lot of promise, with a clear and secure business plan and a wide open market with little competition, are likely to be valued more.
That’s because they are a safer bet. When putting your money toward a company, investors want to know that their piece of the pie will grow as the company continues its operations. Investors factor in the likelihood that a new company will continue to grow in value after its IPO when determining the initial price of shares.
Are IPOs good investments?
Like all investing, it’s good to think of investing in IPOs as a balance of risk and reward. The rewards of IPO investment are potentially very high: if you get in early on a new company that accelerates in its growth, you could end up making a significant amount of money through early investment in an IPO.
However, the risks of IPO investment are also pretty high. Unlike an established publicly traded company, IPOs have not been as well researched by investors, banks, and other authorities. What’s more, nobody knows for certain how they will do once they’re publicly traded. It could turn out that the IPO company struggles under the weight of its new larger size, and suffers from mismanagement.
In general, it’s difficult to say whether IPOs are good investments. The thing to remember is that, while the chance for a high profit is there, it’s accompanied by a substantial risk that your shares will depreciate, or simply not increase in value as quickly as they might if you’d invested in some other company. If you’re not sure whether this is the right path for you, consider a low-risk investment before diving into the world of IPOs.
How to buy IPO stock
Once a company’s stock has gone public, it’s possible to buy it on whatever exchange it’s listed. Usually, you can purchase stocks through a broker or automated brokerage service. It’s possible to purchase IPO stock before it officially goes on the market on a public exchange, but whether this is possible depends on a few other factors, like how open the company is to private market investing, and whether the brokerage firm you work with can get you access to the IPO company prior to its public debut.
For most investors, the way to get started in IPO investment is to set up an account with a brokerage company and buy shares after the IPO has become publicly available. Getting started investing can seem confusing at first, but the good news is that once you get started, you’ll start to understand how the investing world works with real experience. And you can always use the Mint App to track your investments, monitor your funds, and keep an eye on your total net worth.
Initial public offerings: key takeaways
So, what is an IPO? An initial public offering, or IPO, is the first time a privately-held company puts shares onto a public stock exchange for investors to purchase. IPOs occur once a company has reached a certain value, as often happens with startups, or when looking for new investors, which can happen when a larger company decides to go public.
IPO price is determined by economic factors like supply and demand, the company’s total value, and the future prospects that investors believe the IPO company has. You can invest in an IPO through any brokerage once the stock has gone public.
Investor.gov | SEC.gov | Britannica | Morgan Stanley | Fidelity | Corporate Finance Institute