How a company goes public: the IPO in plain terms

An initial public offering, or IPO, is the process by which a privately held company sells shares to the public and lists them on a stock exchange for the first time. It is one of several ways a company can raise capital or let early investors sell, and it is the most visible.

Why companies do it

The stated reasons are usually a mix of three. The company wants to raise money for expansion, acquisitions or debt reduction. Existing shareholders, including founders, employees and venture investors, want a way to sell. And a public listing gives the company a currency, its own shares, that it can use for acquisitions and staff compensation.

The costs are real. Public companies face continuous disclosure obligations, quarterly reporting, governance requirements and scrutiny from analysts and the press. Many companies now stay private longer than they once did because private capital is more available.

The process

A company preparing to list appoints investment banks as underwriters. The banks help prepare the prospectus, a detailed document that describes the business, presents several years of audited financial statements, lists the risks, explains how the money raised will be used and sets out the terms of the offering. The prospectus is filed with the securities regulator, which reviews it for completeness rather than for the merits of the investment.

Once the filing is public, the company and its bankers run a roadshow, presenting to institutional investors. During this period the banks build an order book: investors indicate how many shares they would buy and at what price. This is called bookbuilding, and it is how the offering price is set.

The company and its underwriters then choose a price and allocate shares. Institutional investors usually receive most of the allocation. Retail investors may be offered a portion, depending on the market and the deal.

Pricing and the first day

Pricing is the central tension of an IPO. The company wants the highest price. The underwriters want a price that will hold up and leave investors with a modest gain, which keeps those investors coming back for future deals. The result is often a price set below where the shares trade on the first day.

A large first-day rise is celebrated in headlines but represents money the company did not receive. If shares priced at 20 close at 30, the company sold a stake for a third less than the market judged it to be worth hours later. A flat or slightly positive first day is, from the issuer's point of view, a well-priced deal.

Underwriters typically have an option to sell additional shares if demand is strong, and they may buy shares in the market to support the price in the days after listing.

After the listing

Several features affect how the shares trade. A lock-up agreement prevents insiders from selling for a set period, commonly 90 to 180 days; the expiry date often brings selling pressure. Some companies list with dual share classes, giving founders shares with extra votes, which limits the influence of public investors. The free float, the share of the company actually available to trade, may be small at first, which can make the price volatile.

Alternatives to the traditional IPO include a direct listing, in which existing shares are listed without new shares being sold or underwriters setting a price, and a merger with an already-listed shell company. Each has different costs and disclosure requirements.

Reading an IPO

For anyone evaluating a new listing, the prospectus is the place to start. The risk factors section is written by lawyers to protect the company, but it is also where the real weaknesses are disclosed. The use of proceeds section tells you whether the money is going into the business or to selling shareholders. The financial statements show whether the company makes money and whether it needs the proceeds to keep going.

This guide is general information, not investment advice.