What Is an IPO? How Does It Work?

For investors, an initial public offering (IPO) is a chance to get in on the ground floor at a new publicly traded company. Investing in an IPO allows investors to capitalize on a company’s potential long-term growth, granting the opportunity for more significant profits. 

Institutional investors, investment bankers, and day traders alike look forward to big upcoming IPOs—but what is an IPO, and how does it work? In short, when a company goes public, it transitions from a privately held enterprise to a public one. 

Let’s explore IPOs in greater detail, including their advantages and disadvantages. We’ll also discuss how you can use Composer to invest in companies post-IPO and find ETFs that track IPOs, like the SPAC and New Issue ETF (SPCX).

What is an IPO?

Also known as a stock launch or “going public,” an initial public offering is the first time a private company offers its shares to the general public. Companies go public for various reasons: to raise capital, reduce debt, or pay for business expenses. In return, the new shareholders gain equity in the company, allowing them to generate wealth and vote on crucial company directives.

After an IPO, issued shares trade freely in the open market. Although some brokerages offer IPOs to retail investors, others reserve IPOs for institutional investors. If you want to invest in IPOs in your brokerage account but lack access, consider investments that track an IPO index like the Renaissance IPO ETF (IPO).

How an IPO works

Now that you know what IPO stands for, let’s explore how an IPO works.

1. Gather proposals

The IPO process begins when a company advertises its interest in going public. Companies can solicit private bids or make a public statement to attract underwriters to handle their IPO. 

2. Hire an underwriter

Investment banks typically handle underwriting due diligence, assuming responsibility for helping an issuer sell its shares. A company may select one underwriter or hire several firms and assign specific assignments to each, such as document preparation, filing, or marketing. Underwriters also analyze the company’s valuation and ideal IPO price to ensure it finds a market for all the issued shares.

3. Valuation

Most companies use a fixed-price or book-building offering to set their IPO price. A company sets a single price for its shares in a fixed-price offering. Under a book-building offering, the company provides a 20% price band that investors use to determine how much they’re willing to pay before bidding closes. 

4. Filing and registration

Before listing their shares on a public exchange like the NYSE or Nasdaq, companies must file registration documentation with the Securities and Exchange Commission (SEC). Required documents include:

• Red herring prospectus: This initial prospectus details the company’s financials, market prospects, current shareholders and management, and the intended use for the IPO proceeds. However, the red herring prospectus excludes the proposed IPO stock price and total shares issued.

• S-1 registration statement: This document registers the IPO with the SEC and includes all relevant details about the company and the IPO.

• Underwriting agreement: This document indicates fees and expenses the company will pay the underwriter, typically between 2% and 7% of the offering size.

5. Roadshow

Once the SEC reviews the IPO, the underwriting firm will begin staging presentations to potential investors. Known as a roadshow, this series of presentations aims to generate demand for the IPO and gauge market interest. During the roadshow, investment bankers deliver sales pitches in major cities across the U.S., introducing the IPO to high-profile clients like hedge funds, institutional investors, and mutual fund managers. 

6. Listing and quiet period

The final step in the IPO process involves listing and issuing the company’s shares on an exchange. The 25 days after the initial stock launch is known as the quiet period, during which the underwriting company may take limited steps to stabilize or influence pricing.

IPO alternatives

Although most companies use a traditional IPO to access public markets, others seek IPO alternatives to offer their shares.

Direct listing

Also known as a direct placement or public offering, a direct listing does not employ underwriters and only sells existing, outstanding shares rather than creating new ones. With a direct listing, the company going public gets no marketing support, promotions, or share sale guarantees. This method costs less than a traditional IPO but also incurs more risks.

Back-door listing

In a back-door listing, a private company purchases an already publicly traded company, allowing it to meet registration requirements. This method is sometimes called a reverse IPO or merger because it subverts the normal IPO process. Companies typically use back-door listings when they don’t meet the requirements to list their shares on a stock exchange.

Special purchase acquisition company (SPAC)

A special purchase acquisition company (SPAC) is a shell company without any previous business history listed on a stock exchange. Like back-door listings, SPACs enable private companies to enter the stock market without an IPO. Certain ETFs, such as the RiverNorth Enhanced Pre-Merger SPAC ETF (SPCZ), invest in SPACs due to their equity upside and potential discount. 

Pros and cons of IPOs

IPOs enable growth and expansion but also carry disadvantages that make them unsuitable for certain companies. 

Pros of IPOs

• Capital infusion: Most companies go public to raise capital. Companies use this capital to buy or upgrade equipment, pay off debts, and invest in research and development. 

• Acquisition currency: Private companies may use an IPO to acquire other businesses. Leveraging IPO funds for mergers and acquisitions allows companies to grow without dipping into cash reserves or taking on additional debt, 

• Employee benefits: Some companies utilize IPOs as a bargaining tool for attracting or retaining leadership talent. By offering stock options and other equity-based incentives, companies align their shareholders’ and employees’ interests, creating an environment where workers feel valued.

• Increased public awareness: IPOs often generate significant publicity, drawing awareness to a company and its products. This increased attention from potential customers can translate to additional sales revenue and market share.

Cons of IPOs

• Costs: Stock offerings incur substantial costs that can dissuade private companies from pursuing an IPO. IPO costs include filing financial documents with government regulators, auditing and accounting expenses, and advisory and placement fees. 

• Market volatility: IPO stocks sometimes experience high price volatility immediately after listing on public exchanges, often with unforeseen financial consequences. This turbulence can make investors uneasy, leading to speculation and doubt concerning a company’s actual value. 

• Pressure for quick results: IPOs can pressure companies to favor rapid gains over long-term financial stability. Demand for strong quarterly results from analysts and shareholders may entice company leadership to undertake projects prematurely or make questionable decisions to boost short-term returns.

• Reduced autonomy: Private companies enjoy greater freedom than public ones. Along with the requirement for increased disclosures to investors, public companies also endure stricter regulation from the SEC.

Ready to seize IPOs with confidence and precision?

IPOs let investors grow with companies as they enter the stock market. With Composer, you can design automated strategies that capitalize on this potential growth—no specialized programming skills required. 

Composer’s user-friendly trading experience makes investing in ETFs that track IPOs simple, so you can focus on honing your strategy. Sign up for Composer today and discover the benefits of automated trading.