What are IPOs?

IPOs – a breakdown

Apple. Amazon. Facebook. These well-known tech giants were once startups. Private companies with only a small number of shareholders.

Most companies have humble beginnings, sometimes funded by the savings of the founders, or by investments from family and friends. In some instances, these private companies do very well.

To continue their growth, they will likely need more capital (money). One way of raising this capital is by taking the company public through an Initial Public Offering (IPO).

What is an IPO?

An Initial Public Offering is a process through which private companies offer shares to the public via the stock market for the first time.

A private company often has a small number of shareholders including early investors. This could include the founders, family and friends, as well as professional investors.

Taking the private company public allows a wider audience of investors to purchase shares in the company and become shareholders. By issuing (selling) these new shares, a company can raise capital, which could be used to help fuel growth. It also gives access to investors who had previously been unable to invest in the company.

How do IPOs work?

Imagine a private company with a small group of shareholders. The company decides it wants to allow more investors to buy shares via an IPO. This is often described as 'going public'. The company plans to issue a certain number of new shares, each with a percentage stake in the company. The number of shares issued can vary from company to company.

The company hires advisers which include investment banks, accountants and lawyers, collectively known as the origination team. The origination team help to facilitate the process for the company, produce the paperwork and negotiate meetings with potential investors to stir up demand for the soon-to-be available shares.

The company will work with accountants, lawyers and investment banks to prepare for the IPO. Together, they will produce a document known as a prospectus. This is a formal legal document that provides detailed information about the company, its financial performance, risks and the terms of the offering, helping potential investors make informed decisions.

The application process

After the prospectus is released, an application process will then be opened, known as the ‘offer period’. The offer period can last a week or more. This gives investors time to assess the offer information and submit bids indicating the number of shares they are willing to purchase.

During this period, no individual investor knows how much demand there is from other investors. When the offer period closes investors are allocated the shares based on their applications. Sometimes investors may not receive their full allocation if the offer has been oversubscribed.

After the offer period closes, an initial price will be decided for these shares based on the company’s valuation, assets, demand for shares and a range of other factors. Afterwards, the company issues the new shares which are listed on a stock exchange. The shares can be bought or sold during normal market hours and the price of the shares can rise and fall.

Can companies choose which exchange to list on?

Yes, companies can choose which exchange to list on, such as the New York Stock Exchange (NYSE), or London Stock Exchange (LSE). The company will need to meet the specific requirements of each exchange and financial regulators.

Why do companies go public?

An IPO is an opportunity for the company to open itself up to investors and raise new capital. The range of this capital can be vast, for example Facebook went public in 2012 and raised over $16bn. This can be used to fund expansion, invest in new projects or accelerate growth. Companies can choose to go public at different stages of development, and how much they raise can depend on their goals, demand for shares and the valuation of the company.

However, it is not always established companies which go public. In specific circumstances, some companies with strong business fundamentals can qualify for an IPO. This is common in the pharmaceutical industry, where product development to realisation can have longer timelines. For example, one biotech company that went public in 2021 raised over $500mn despite having no physical product at the time.

What’s in it for investors?

For investors, the opportunity to invest in a company early is often the biggest motivation.

By investing in a company when they first go public, there is potential to invest while the share price is lower than you feel it could become as the company grows. This ‘potential’ is one of the factors investors take into account when buying shares in an IPO.

It is said when companies go public, they are entering the beginning of their second life cycle. Investing in its IPO means you can be part of that journey. Investors can benefit from future growth and, in some cases, dividends over time, but you could also receive dividend payments and other benefits linked to being a long-term shareholder.

What are the risks of IPOs?

IPOs are not a guaranteed golden ticket to success. Many companies go public and fall short of expectations.

Investing in IPOs and individual companies isn’t right for everyone. It’s a higher-risk way to invest your money. The value of your investment depends on the fate of that company. If it fails, you risk losing your whole investment.

Potential price swings

You shouldn’t invest in an IPO simply because it is gaining positive attention. Volatility is a significant risk that investors need to be aware of. During the first few weeks of trading, the excitement around an IPO can lead to vast speculation, causing price swings both up and down. These swings may not be a representation of the true value of the company.

Lack of a proven and financial track record

Unlike established companies, IPOs often lack a proven and long financial track record which is a good research tool when assessing a company. IPOs may lack historical data, making it a riskier investment than more established companies. Although how a company has performed in the past isn’t a promise of future success.

Larger legal, accounting and marketing costs

Becoming a public company comes with increased legal, accounting and marketing costs for the business and impacts its financials.

How can I invest in an IPO?

You’ll usually need to apply for shares during the offer period through an investment platform or broker. If you don’t have one already, you can open one with Hargreaves Lansdown in minutes. You’ll indicate how many shares you’d like (and sometimes the price you’re willing to pay, if a price range is set).

You may get fewer shares than requested depending on whether demand is high. Once the shares are listed on a stock exchange, you can also buy them like any other publicly traded stock.