IPO Basics: What Is An IPO?

An initial public offering, or IPO, is the very first sale of stock issued by a company to the public. Prior to an IPO the company is considered private, with a relatively small number of shareholders made up primarily of early investors (such as the founders, their families and friends) and professional investors (such as venture capitalists or angel investors). The public, on the other hand, consists of everybody else – any individual or institutional investor who wasn’t involved in the early days of the company and who is interested in buying shares of the company. Until a company’s stock is offered for sale to the public, the public is unable to invest in it. You can potentially approach the owners of a private company about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of their shares to the public to be traded on a stock exchange. This is why an IPO is also referred to as "going public."

A privately held company has some benefits that are forfeited once it goes public. For example, its owners do not have to disclose much financial or accounting information about the company. In the United States, it is easy and relatively inexpensive to found a private company, and most small to medium sized businesses are private. But large companies can be private too. For example, IKEA, Publix Supermarkets, Mars Candy, and Hallmark Cards are all privately held.

Public companies have thousands of shareholders and are subject to strict rules and regulations. They must form a board of directors and they must report auditable financial and accounting information every quarter. In the United States, public companies report to the Securities and Exchange Commission (SEC). In other countries, public companies are overseen by governing bodies similar to the SEC. In addition, public companies must adhere to regulations and requirements set forth by the stock exchanges where their shares are listed. Being on a major stock exchange carries a considerable amount of prestige. Historically, only private companies with strong fundamentals and proven profitability potential could qualify for an IPO and it wasn't easy to get listed. Today, with competition among many stock exchanges, listing requirements have relaxed a bit.

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Why Have an IPO?

Why go public, then? Going public raises a great deal of money for the company in order for it to grow and expand. Private companies have many options to raise capital – such as borrowing, finding additional private investors, or by being acquired by another company. But, by far, the IPO option raises the largest sums of money for the company and its early investors. Some of the largest IPO’s to date are:

• Alibaba Group (BABA) in 2014 raising $25 billion
• American Insurance Group (AIG) in 2006 raising $20.5 billion
• VISA (V) in 2008 raising $19.7 billion
• General Motors (GM) in 2010 raising $18.15 billion
• Facebook (FB) in 2012 raising $16.01 billion

Being publicly traded also opens many financial doors: Because of the increased scrutiny from analysts and investors, public companies can usually enjoy better (i.e. lower) interest rates when they issue debt. Moreover, as long as there is market demand, a public company can issue more stock in a so-called secondary offering. Thus, mergers and acquisitions are easier to arrange because stock can be issued as part of the deal.

For investors, trading in the open markets means liquidity. If you are a shareholder of a private company, it is very difficult to sell your shares, and even more difficult to value your shares. A public company trades on a stock market, with ready buyers and sellers and known price and transaction data. The stock market is therefore referred to as the secondary market, since investors are buying and selling stock from other public investors and not from the company itself. Public markets and liquidity also makes it possible for a company to implement benefits like employee stock ownership plans (ESOPs), which help to attract top talent.

Pros and Cons of an IPO

Pros:

• A large, diverse group of investors to raise capital
• Gives the company a lower cost of capital
• Increase the company’s exposure, prestige, and public image, which can help the company’s sales and profits
• Public companies can attract and retain better management and skilled employees through liquid equity participation (e.g. ESOPs)
• Facilitating acquisitions (potentially in return for shares of stock)
• Raises the largest amount of money for the company compared to other options

Cons:

• Company becomes required to disclose financial, accounting, tax, and other business information
• Significant legal, accounting and marketing costs, many of which are ongoing
• Increased time, effort and attention required of management for reporting
• Risk that required funding will not be raised if the market does not accept the IPO price, sending the stock price lower right after the offering
• Public dissemination of information which may be useful to competitors, suppliers and customers
• Loss of control and stronger agency problems due to new shareholders, who obtain voting rights and can effectively control company decisions via the board of directors
• Increased risk of legal or regulatory issues, such as private securities class action lawsuits and shareholder actions

An IPO, to recap, is when the company sells stock to the public. If a firm can convince people to buy stock in the company, it can raise a lot of money. The IPO is seen as an exit strategy for the company founders and early investors to profit from their early risk taking in a new venture. Therefore, in an IPO many of the shares sold to the public were previously owned by those founders and investors.

The stock market is referred to as the “secondary market,” since traders buy and sell stock from other public investors, and not from the company itself. Only prior to the IPO does the company issue stock directly to shareholders. This means that when you buy shares of a company, you are not handing your investment money over to the corporation, but instead to whomever sold you their shares. When a company sells shares to the public, the company and its owners still typically retain a significant portion of the total stock, so some early investors and co-founders may still have a great deal of influence on the direction of the company despite there being a large number of new shareholders.