If you're at all familiar with the world of investing, you've probably heard the term "IPO" before. However, when you're a new investor, it can be hard to understand what an IPO is and how it works. In light of that, we've created this guide to initial public offerings. Keep reading to learn more about this investment opportunity.
What is an IPO?
An initial public offering (IPO) is the process of raising capital by issuing to the public new shares of stock in a formerly private company. After an IPO, shares of the company will be publicly traded on one of the stock exchanges.
How does an IPO work?
Before an initial public offering, companies are privately owned (or "privately held"). At this point, they typically have only a few investors. These are often the founders of the business, family members, close friends, venture capitalists, or angel investors.
However, at a certain point, a company reaches a stage in its growth where it needs more capital than those initial investors can provide. At the same time, the company must believe it is mature enough to stand up to Securities and Exchange Commission (SEC) regulations and to fulfill its responsibilities to public shareholders.
Typically, this point arrives when the company has reached "unicorn status," or a private valuation of $1 billion. That said, in some cases, companies with lesser valuations and proven profitability may also start to undertake the IPO process. At this stage, the company will begin advertising a public offering.
The seven steps of the IPO process
- Proposals: Once a private company starts to advertise its intent to do a public offering, underwriters will present proposals for the job of assisting with the company's IPO. They will present a valuation, an offering price, an estimated number of shares, and a time frame for the process.
- Underwriting: After the company chooses its lead underwriter, it will sign an underwriting agreement to start working together on the necessary due diligence.
- Team formation: Next, the issuing company will put together a team of experts, including underwriters, certified professional accountants (CPAs), and SEC professionals to help them through the process.
- Documentation: Once the team has been established, they will set about putting together the required documentation for the offering. In particular, they need to put together an S-1 registration statement, which is the IPO filing document, and a prospectus, which provides details about the offering to public investors.
- Marketing: After the S-1 registration statement and preliminary prospectus have been completed, the issuing company will work on meeting the other SEC regulations. At the same time, it will partner with its underwriter to market the IPO so it can gauge the interest of potential investors and determine an official offering price.
- Board formation: Next, the company will form a board of directors. The board will be responsible for reporting the appropriate financial information each quarter.
- Issuing shares: Finally, on the date of the company's IPO, the shares will be issued. The company receives any capital as cash, and the IPO shares are recorded as shareholder equity in the company's financial records.
What are the advantages of investing in an IPO?
Ultimately, there are quite a few reasons why you might want to invest in a stock as soon as it hits the public market. We've laid out the biggest ones for your consideration below.
IPOs have a strong potential for capital gains
Unless you're a very wealthy investor, you likely don't have the resources to invest in private companies. Taking advantage of an IPO is the closest many individuals can get to investing at the very beginning of a company's growth journey.
If a traditional IPO goes well, the value of the company's stock will only increase as interested investors continue trading shares. As an early investor, this can potentially give you plenty of opportunities to see large capital gains and lots of dividend income.
Investing in a public company fosters growth
The other advantage of investing in a public company is that it contributes capital to the economy and enables companies that provide essential goods and services to continue to grow. While this may seem a bit altruistic, it's an important factor that should be considered by investors as they navigate the stock exchange.
What are the disadvantages of investing in an IPO?
Still, there are also some disadvantages to investing in an IPO. We've laid them out for you as well to help you make the best decision possible.
IPO stock can be especially volatile
Public investors should be aware that a company's stock price can be particularly volatile following an IPO. If you're not prepared to weather the storm, you risk letting the market guide your investment strategy instead of look-through earnings and dividend growth.
Research can be time-consuming
If you're thinking of investing in an IPO, it's crucial to do your research. In particular, you're going to want to study the company, its executive team, and its performance over time. All of that can be time-consuming. However, it is necessary to make sure you are making an informed investment decision.
How to evaluate an IPO stock
Read the S-1 and prospectus
The first step in evaluating an IPO stock should be to read the company's S-1 registration statement and prospectus or, at the very least, the summary. Together, these documents will give you a thorough look into the company's operating and financial history, its products and services, its primary market, and its competition.
Notably, these documents will also list the company's risk factors, which will also be a huge help when doing your due diligence. You can find these documents by going to the SEC EDGAR website and typing in the company name.
Consider the life cycle and earnings potential
In addition, you'll want to consider where the company is in its life cycle as well as its earning potential. In particular, these metrics can help you decide how quickly you need to move on a given opportunity.
For example, a young company with extremely high demand and long-term earnings potential may be worth moving on faster than a more established company with tepid earnings and demand.
The Millionacres bottom line
Investing in an IPO is always a risk, but it has the potential for a very high reward. It's important to do your research into any company in which you are considering investing. However, if you have specific questions, it may be worth reaching out to a financial advisor.