Understanding IPOs

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Narrator: An IPO, or Initial Public Offering, is the initial sale of a company's stock to the public.

Prior to the IPO, the company's stock is privately held and cannot be sold to the public.

Startup companies may go public to raise money to develop and grow their business. Other companies may go public to expand existing products or services.

There are some other advantages to going public.

Companies can raise capital without increasing debt and allow existing shareholders to profit from company growth by liquidating their shares.

But on the flip side, public companies have increased reporting requirements and additional marketing, accounting, and legal costs.

So how exactly does a company go public?

First, a company gets the help of an investment bank to underwrite the public offering of shares.  This means they set the price for how much each share sells for. In turn, the underwriter gets a commission on the sale of these shares.

Often, the lead underwriter will gather other investment banks into a syndicate, allowing more institutions to get involved.

The company, along with the underwriting syndicate, will develop a prospectus—a report detailing the specifics of the offering—and will register with the SEC and then get purchase commitments from institutional investors, brokers, and other banks.

These groups then make the shares available, generally to high-value customers, typically in exchange for holding the stock for a period of time.

This placement of shares is the Initial Public Offering.

Once the IPO is complete, shares start trading on a stock exchange.

It's here that the stock price is determined by market forces, not the underwriters or company.

Often, there is a great deal of excitement driving buying and selling.

Investors interested in participating in the initial placement should check with their broker for share availability.

But for the average retail investor, buying shares at the offering price before the stock starts trading is difficult. Most will have to wait until it trades on the stock exchange.

It's important to realize that the risk of an IPO varies based on the company going public. Some companies have a long history of earnings growth prior to going public, while others might be going public to generate money to pay their bills. There are also risks common to most IPOs, including the lack of previous trading history, limited company information, and initial price volatility. And the risk of loss is substantial.

But with the risk of loss comes the potential for profit as well.

And this potential is one reason many traders pay so much attention to IPOs.

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