Definition of Initial Public Offering

Initial Public Offerings, most commonly known as IPOs, are done when a company decides to go public. Don’t worry if that doesn’t make any sense to you, it will by the end of this lesson.

Let’s look at the journey of a single business. It starts in a garage in the founders basement. Their great idea gets picked up and they eventually manage to rent a building. A year or two later that same company can finally purchase a small headquarters to run operations through. Their product is incredible. Everyone who uses it loves it. The problem is that growing a business costs money. If there is a demand for 1 million products, but you only have enough cash to order 100,000 from your manufacturer, you are limiting your growth due to lack of funds.

An IPO is a way to solve this. Instead of going out and getting a loan from a bank, a private company will seek out investors who believe in their company. They will offer ownership in the company in return for a certain amount of cash. Once a company decides to offer ownership to the public via shares in the stock market, they have an IPO. This is essentially the day the company makes the shares available to the general public (hence the name – INITIAL public offering).

Investors who purchase a companies stock during an IPO do so because they believe that the company will be able to grow, and those shares of the company that they own will be worth a lot more. They hope to someday sell those shares at a profit.

A typical initial public offering will involve millions of shares and often billions of dollars.

facebook IPO
One of the most successful IPOs of this decade was Facebook. Those that invested have seen steady increases virtually every year.

Steps to an IPO

An IPO does not just happen overnight. In fact, many IPOs that are happening this year likely started talking about a public offering two or three years ago. The process has very strict rules and is watched over by the Securities and Exchange Commission (SEC).

  1. The first step towards a public offering is for the company to approach what is called an investment bank. You have likely heard of some of the big investment banks such as Goldman Sachs, Morgan Stanley, or JPMorgan Chase. The company could technically do it on their own, but most companies choose to use experts. The investment bank they choose will likely get other investment banks involved so that they can diversify their risk.
  2. Once an investment bank is chosen then it is time to approach the SEC. A form is filed with the SEC that explains everything that will be happening. It is extremely important for a company to have accurate and honest financial statements and legal documents during this period. The SEC will want to review the companies balance sheets and income statements to be sure that the general public is not being deceived in any way.
  3. The SEC will likely audit the company and make sure everything is as they say it  is.
  4. The company and their investment banker will begin what is called a road show. This is to get the name out and help potential investors learn about the company. They will approach big hedge funds and companies that manage large amounts of money and sell them on the new IPO.
  5. Eventually they enter what is called a quiet period. This is basically a time when the company cannot make any new announcements that would potentially inflate the stock price on the day of the IPO. During this time the SEC is extremely strict on what public statements a company can and cannot make.
  6. The next step is choosing an exchange. You have likely heard of a few exchanges such as the Nasdaq. These exchanges try to convince companies to use their exchange because it leads to more money for them. In the end, the company can choose the exchange they would like to trade on.
  7. The company in this period will also choose how many shares and what to price the shares at. It is not uncommon during this period to see the company change the initial price of shares based on public sentiment about the IPO.
stock market IPO courses

Investing in the IPO

Unfortunately it is extremely hard for beginners and small investors to invest in IPOs. They will likely have to wait until the IPO is complete and the shares of stock are freely available to purchase through their online stock broker. This is because the investment bankers aren’t looking for someone to buy a couple thousand dollars in shares. That is what stock exchanges are for. They are looking for large institutions to purchase hundreds of millions of dollars in shares.

There are some startups that have recently started trying to help beginning investors invest in IPOS. One company is Loyal3. If you are interested in getting in on the IPO of a company that you have heard of, you may try using one of these startups.

The better question with IPOs may not be whether you can, but whether you should. Here are a few price charts from recent IPOs (as of 2016).

stock market ipo for beginners
Etsy IPO

If these charts don’t make sense to you go ahead and visit the lesson on how to read stock charts. As you can see those people that bought into either of these IPOs at the beginning lost up to 90% of their investment. Yes, the reverse can happen as well, and many investors do very well investing in IPOs, but there is a certain level of risk that comes with an IPO that a large number of investors just don’t feel comfortable with.

The reason for this is that there is no price history to be had. Technical analysis, a method most investors use to determine when to purchase shares of stock, requires looking at past chart patterns and seeing when a good time to purchase and sell shares would be. With an IPO there are no past price patterns, making technical analysis impossible.

If you insist on investing in IPOs and feel good about it always bear in mind that IPOs are typically done as a long term investment. Because you do not have stock charts to base price on, it will fluctuate a bit until investors feel comfortable. If you have a long term mindset when you invest in an IPO you will not be bothered by the day-to-day swings in the stock price. You will understand that these happen naturally with every company, and speak nothing of the company’s future success.

It may also be a good idea to set a stop loss on an IPO investment to avoid catastrophic losses such as those shown in the pictures below. See the lesson on stock order types if you are unsure what a stop loss is.