Become a better investor
Lesson in Course: Medes Newsletter (advanced, 4min )
A basic primer about IPOs. What are they and how do they work?
IPOs — you hear about them all the time in the news and how they create millionaires overnight. But what are they and how do they work?
IPO stands for initial public offering and occurs when a private company decides to open up its capitalization table (or ownership) to the public. Companies do this to raise money for growth and allow early investors and employees to cash out.
There are two different ways for a company to go public. Traditionally, a company can hire bankers to help with raising cash. Recently we’re seeing companies go public without hiring bankers — more on this below.
After becoming public, current owners in the company including venture capitalists, founders, and employees will be able to sell the shares they own on the open market to new public investors.
Let’s review the two ways to go public below.
Investment banks are hired to help the company issue and sell new shares to the public. The company pays the bankers a fee (floatation cost), often in the 10s of millions of dollars, to help price the shares being sold and to find buyers at that price. The offering put together by the bankers is not available to the majority of the public but is put in front of professional money managers who have relationships with the investment banks. The money managers will commit to buying a certain amount of shares at the set price. If people want to buy more shares than are available for sale, the offering is considered oversubscribed. Conversely, the offering is undersubscribed if there are shares left unsold.
If oversubscribed, the company can decide to work with the bankers to raise the price of the shares and as a result raise more money for the offering. If undersubscribed, the company can either take what is offered or lower the price to see if they can find more buyers. Once this process is completed the company is ready to trade on the day of the public offering.
On the day of the public offering, everyone is now able to buy shares of the newly traded company through their brokerages such as Robinhood or E-Trade. The amount of buyers vs sellers drives the price of the stock either up or down. These shares being purchased are generally sold by other participants in the public offering — the money managers that had first dibs.
Employees and insiders of the companies are usually subject to a lockup period ranging traditionally from 90–180 days during which they cannot sell their shares. An interesting note on the history of lockups: some States enacted Blue Sky Laws to prevent “pump and dump” schemes where insiders would sell overpriced shares to the public to profit before the price went down. These laws are still on the books today and bankers include them in their IPO contracts so that insiders cashing in won’t create massive selling imbalances and tank the stock price.
Certain companies like Slack and Spotify have been changing the traditional IPO model by going public with something called a direct listing. In contrast to hiring bankers, a direct listing is when the company does not issue any new shares and instead sells existing shares held by founders, employees, and venture capitalists. By going the direct listing route employees and insiders are not subject to a lockup period and can sell right away.
Without a bank to line up buyers, the price is set by the company and the supply and demand on the day of the listing will cause the stock price to either go up or down.
Regardless of the process chosen by the company, public companies are highly regulated by the SEC (US Securities and Exchange Commission). Going public requires fair representation of the current health of the business including risks, financial position, and some general guidance (predictions of future company performance) from the executives at the company. This information is packaged up in a prospectus S-1 which is filed with the SEC, can be read by anyone before the IPO, and is often helpful to decide whether you should buy the shares on the day of the IPO.
Check out this discussion on WeWork’s recent S-1.