An IPO, or initial public offering, refers to privately-owned companies selling the business’s shares to the general public for the first time.
“Going public” has benefits: it can boost a company’s profile, bring prestige to the management team, and raise cash to expand the business.
But there are downsides to going public as well. The IPO process can be costly and time-consuming, subjecting the business to high scrutiny.
Meanwhile, there are pros and cons for folks considering investing in a company’s IPO. Here’s a deep dive into IPOs.
How Do IPOs Work?
An initial public offering (IPO) refers to the first time a company offers shares of stock to the general public. A company cannot legally sell stock to the public until the transaction has been registered with the Securities and Exchange Commission (SEC).
Before an IPO, a company is “private,” meaning that stock shares are unavailable for sale to the general public. Also, a private company is not generally required to disclose financial information to the public.
A company must file a prospectus with the SEC to have an IPO. The company will use the prospectus to solicit investors, including key information like the terms of the securities offered and the business’s overall financial condition.
Behind the scenes, companies typically hire investment bankers and lawyers to help them with the IPO process. The investment bankers act as underwriters or buyers of the shares from the company before transferring them to the public market. The underwriters at the investment bank help the company determine the offering price, the number of shares that will be offered, and other relevant details.
The company will also apply to list its stock on different exchanges, like the New York Stock Exchange or Nasdaq Stock Exchange.
History of IPOs
While there are some indications that shares of businesses were traded during the Roman Republic, the first modern IPO is widely considered to have been offered by the Dutch East India Company in the early 1600s. In general, the Dutch are credited with inventing the stock exchange, with shares of the Dutch East India Company being the sole company trading in Amsterdam for many years.
In the U.S., the Bank of North America conducted the first American IPO, likely in 1783. A report claims investors hiding cash in carriages evaded British soldiers to buy shares of the first American IPO.
Henry Goldman led investment bank Goldman Sachs’ first IPO–United Cigar Manufacturers Co.– in 1906, pioneering a new way of valuing companies. A challenge for retail companies at the time was that they lacked hard assets, as other big businesses like railroads had. Goldman pushed to value companies based on their income or earnings, which remains a vital part of IPO valuations today.
Recommended: A Brief History of the Stock Market
Why Does A Company IPO?
Answering the question, “what’s an IPO?” doesn’t explain why a company “goes public”—an essential detail in the process. Because an IPO requires significant time and resources, a business probably has good reason to go through the trouble.
Raising Money
A common reason is to raise capital (money) for possible expansion. Before an IPO, a private company may procure funding through angel investors, venture capitalists, private investors, etc.
A company may reach a size where it can no longer procure enough capital from these sources to fund further expansion. Offering stock sales to the public may allow a company to access this rapid influx of investment capital.
Exit Opportunity
An IPO may allow early stakeholders, such as angel investors and venture-capital firms, to cash out of their holdings. Venture-capital firms, in particular, have investors that need to provide returns. IPOs are a way for them to transfer their share of a private company by selling their equity to public investors.
More Liquidity
Venture-capital firms and angel investors aren’t the only ones who may be seeking more liquidity for stakes in companies. Liquidity refers to the ease with which an investor can sell an asset. Stocks tend to be much more liquid assets than private-company stakes.
Hence, employees with equity options can also use IPOs to gain more liquidity for their holdings, although they are usually subject to lock-up periods.
Publicity
From the roadshow that investment banks hold to inform potential investors about the company to when executives may ring the opening bell at a stock exchange, an IPO can bring out more significant publicity for a company.
Being listed as a public company also exposes a business to a broader variety of investors, allowing the business to obtain more name recognition.
Pros and Cons of an IPO
As with any business decision, there are downsides and risks to going public that should be considered in conjunction with the potential benefits. Here’s a look at a few:
Pros
1. A company’s public offering may provide an opportunity to raise capital on a scale that might not be possible with other forms of capital generation. This capital can be used for business expansion, infrastructure buildout, intensive research, or other activities that require a large amount of upfront cash.
2. An IPO may expand opportunities for future access to capital. They can issue more stock and may also be able to attract business partners, potential investors, or other opportunities.
3. An IPO may increase liquidity for a company’s stock, allowing owners and employees to exercise options and sell shares more easily.
4. Having publicly-traded stocks can be helpful in mergers and acquisitions. A company may be able to acquire other businesses by using their stock as payment.
5. An IPO can create publicity and brand awareness for a company. Also, there’s no denying that an IPO provides some prestige for a business.
Cons
1. Going public is expensive and time-consuming. Every company should consider conducting an extensive cost-benefit analysis before pursuing an IPO.
2. A public company’s initial disclosure obligations may begin with the registration statement they file with the SEC, but that is far from the only filing requirement. Public companies must regularly inform their shareholders by filing periodic reports and other materials.
A public company takes on significant new obligations, such as filing quarterly and annual financial reports with the SEC, keeping shareholders and the market informed, and running extensive internal controls tests required by the Sarbanes-Oxley Act of 2002.
3. A company and its management may be liable if legal obligations (such as filing quarterly and annual financial statements) are not satisfied.
4. A private company will generally report to a smaller group of investors and has more control over who those investors are. Management at a publicly-owned company may have to consider shareholders’ opinions and may lose some managerial flexibility.
5. When a company is public, it must share important information about the business, such as financial statements and disclosures, contracts, and customers and suppliers. This exposes a company to a considerable amount of scrutiny. This information is also available to a business’s competitors.
IPO Alternatives
Since the heady days of the dot-com bubble, when many new companies were going public, startups have become more disgruntled with the traditional IPO process. Some of these businesses often complain that the IPO model can be time-consuming and expensive.
Particularly in Silicon Valley, the U.S. startup capital, many companies are taking longer to go public. Hence, many unicorn companies emerged–businesses with valuations of $1 billion or more significant.
In recent years, alternatives to the traditional IPO process have also emerged. Here’s a closer look at some of them.
Recommended: Guide to Tech IPOs
Direct Listings
Private companies skip hiring an investment bank as an underwriter in direct listings. A bank may still advise the company, but its role tends to be smaller. Instead, the private company relies on an auction system by the stock exchange to set its IPO price.
Companies with more prominent name brands that don’t need the roadshows tend to pick the direct-listing route.
SPACs
Exceptional purpose acquisition companies or SPACs have become another common way to go public. With SPACs, a blank-check company is listed on the public stock market.
These businesses typically have no operations, but instead, a “sponsor” pledges to seek a private company to buy. Once a private-company target is found, it merges with the SPAC, going public.
SPACs are often a speedier way to go public. They became wildly popular in 2020 and 2021 as many famous sponsors launched SPACs.
Recommended: Why Are SPACs Suddenly So Hot
Crowdfunding
Crowdfunding is collecting small amounts of money from a bigger group of individuals. The advent of social media and digital platforms has expanded the possibilities for crowdfunding.
One 2020 report found that $17.2 billion is generated in North America annually through crowdfunding. The average crowdfunding campaign has raised $824, with the average pledge by a backer by $88.
Staying Private
In recent years, tech companies have been taking their time before debuting in the public stock market, finding more avenues for funding as the venture-capital world has expanded.
Going public is an expensive, often arduous process. Investment-bank fees can take up 4% to 7% of an IPO’s proceeds. Business publications have followed this trend, pointing to how the average age of a VC-backed U.S. company in 2013 going public was seven years. By 2018, it was ten years. This has led to the proliferation of so-called unicorns—privately held companies valued at greater than $1 billion in Silicon Valley.
New IPO Routes in Tech
The IPO market experienced somewhat of a resurgence in 2020 as the stock market reached new peaks. But when companies have been going public, they’re often experimenting with alternatives to the traditional IPO.
SPACs, or particular purpose acquisition vehicles, have been one way. Also known as blank-check companies, SPACs raise money through an IPO and then look for companies to merge with. They often have a two-year time horizon to find an acquisition.
For startups, merging with a SPAC can offer a speedy way to go public as opposed to the drawn-out process of an IPO. Media reporting in October noted that SPACs raised $51.3 billion in the U.S. in 2020, the highest ever and almost half the amount raised by IPOs.
Direct listings are another route tech companies have tried. In a direct listing, companies forgo hiring an investment bank as an underwriter. In such listings, banks may still play a minor advisory role, but companies instead rely on the auction by the stock exchange to set their IPO price.
No new money is raised in direct listings, meaning they’re typically done by cash-rich companies already widely recognized by the market and the public. Data-mining company Palantir and corporate software maker Asana also chose to go public via direct listings. At the same time, news outlets have also reported that Airbnb had considered this route before deciding on a traditional IPO.
Pros of Tech IPOs
Inventor enthusiasm coupled with buoyant equity markets can propel shares of newly public stocks.
The Renaissance IPO Index surged 88% in 2020 through Nov. 20. The gauge tracks companies that have gone public roughly in the last two years. The index’s rally vastly outpaced the benchmark S&P 500’s 12% gain over the same period. Tech stocks comprise a little over half of the IPO index.
Tech companies can also offer growth opportunities for investors. For instance, while the global COVID-19 pandemic has battered results for many industries, Silicon Valley names have been a bright spot when it comes to revenue, as consumers have been stuck at home, conducting their activities and making purchases virtually.
Cons of Tech IPOs
Tech IPOs also pose risks for investors. Because some companies haven’t been around for that long, they may not yet be profitable. This means that the IPO valuations could be too high.
Investors experienced the brunt of this firsthand when the dot-com bubble burst in the early 2000s, causing a slew of newly public tech stocks to shutter.
Much-hyped IPOs may also disappoint in terms of price performance. Data from Dealogic shows that since 2010, around a quarter of U.S. IPOs have seen losses after their first day.
KEY TAKEAWAYS
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Startups may also call themselves tech firms or be grouped into the industry, even when the actual technological features of their businesses are more limited.
Regulation and government oversight of tech companies could also be changing. In October, the U.S. Justice Department filed an antitrust lawsuit against Google, alleging that the search company uses anti-competitive practices. Such cases could have widespread ramifications for tech companies regarding their regulatory landscape and competitive practices.
The Takeaway
Buying IPOs of tech firms can offer investors an opportunity to invest in high-growth stocks. However, potential pitfalls include high valuations for an unseasoned company and disappointed share price performance after the listing.
For investors, the IPO prospectus can be a valuable research tool if they’re looking to invest in a tech company with a listing coming up.
Of course, IPOs aren’t the only way investors can access Silicon Valley companies, even if they seem to grab many headlines. Investors can buy shares of tech names that have been public for years.
