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What is an IPO and how does it work?

What is an IPO and how does it work?
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An initial public offering (IPO) refers to the first sale of stock by a company to the public. Here is how it works.

How does an IPO work?

An IPO begins with a company deciding that it wants to issue stock to the public. While there are a significant number of legal and accounting steps involved, here is a general summary of the process.

First, the company hires an underwriter, usually an investment bank, to advise and walk it through the IPO process. It may also hire a third-party accounting firm to conduct a complete audit of its finances.

With the help of the investment bank, the company drafts and prepares relevant registration documents which it then files with the Financial Conduct Authority (FCA), the official regulator of financial markets in the UK.

This includes a prospectus (detailed financial information about the company, reasons for the IPO and details about the offer itself), information about the company’s management and its business plan. The FCA reviews the documents to make sure that they’re accurate and complete.

The FCA might then accept the application (sometimes subject to certain amendments) or reject it. If approved, a date for the IPO is set.

Who sets the IPO price?

The underwriter sets the price of shares. The company first decides how much stock it wants to sell. The bank then conducts a valuation of the business and proposes a price for the shares.

Why do companies go public?

An IPO’s main purpose is to raise capital for a company which can be used for various purposes. For example, the company can use the money to expand geographically or expand it’s range of products. Or it can use the money to pay off debts.

Some companies also offer employees a formal stake in the company through shares. They do so in the hope of being able to attract and retain high-quality talent.

When can a company go public?

Companies don’t start an IPO upon launch. For most, it takes time to establish a solid market position to attract investors and meet the regulator’s qualifications.

Many tend to file for an IPO when they reach a point where their growth plans can’t be supported solely by funding from angel investors, private investors or venture capital. A company will go public when it wants the significant influx of cash that only an IPO can provide.

How can I buy IPO stock?

Unlike most stocks, which you can simply buy using your share-dealing broker, IPO stocks are usually pre-sold to specific investors, most often institutional investors. Orders have already been filed by the day of going public.

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As an individual investor, it might therefore be hard to get into an IPO before the first day of trading.

Here are the only ways through which you can get IPO stock:

1. An online brokerage who receives shares

Some brokerages may be allocated shares by an investment bank to sell to their members. So, if you’re interested in an IPO stock, check with your broker to get details of how to acquire it.

2. An investment bank

Many investment banks, including the original underwriter, have access to IPO stock, most of which will go to their customers. Developing a relationship with an investment bank can help you acquire IPO stock.

3. A mutual fund with IPO stock

Some mutual funds might be sold IPO stock. Although you won’t own the stock directly, you’ll still benefit by it being part of your overall portfolio.

4. Via a share dealing account

If you have a share dealing account, you might be able to buy shares of a company the first day it goes public.

But keep in mind that you’ll probably not buy at the offer price. The price you buy at will reflect the demand for the stock the day it makes its public debut, so it might be higher.

Is IPO stock good for new investors?

Needless to say, the promise of immediate profits from an IPO should not impact your long-term investment strategy. On one hand, early entry into the right IPO stock can lead to high gains. But IPOs also tend to be volatile and unpredictable. 

Pent up investor demand often leads to stocks shooting up in value on the first day of trading. This can sometimes be followed by a massive correction, where stocks fall back to their offer price and sometimes even below it. 

For these reasons, individual investors who want to buy stock in newly listed companies might be better off waiting.

If you hold off for a few months, you can let the initial volatility work itself out, or for the hype to die down, and the stock to stabilise. While you might miss out on the occasional explosive gains of hot stock, this might prove to be a much safer strategy in the long term. 

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