An initial public offering (IPO) is the financial mechanism by which a private company offers stock to the general public for the first time and officially becomes a publicly traded company. Initial public offerings are often exclusive events, with the majority of the stock going to institutions and well-connected individual investors. Historically, initial public offerings have performed extremely well in the after market (when the new stock trades freely on the stock market for the first time), and therefore are much sought-after investment opportunities. For example, when UPS went public in November of 1999, the stock opened 30 percent higher than the initial public offering price.
Every publicly traded company began with an initial public offering. It is the only way for a company to sell stock to the public and have that stock listed on one of the various stock exchanges. Every company must meet the listing requirements of their respective exchange, and file all the proper regulatory paperwork with the Securities Exchange Commission prior to their initial public offering.
When a private company decides to go public, they contact an investment bank. The investment bank performs their due diligence and determines how much the company is worth on the open market. This can be a fairly arbitrary number, so it is open to negotiation between the company and the investment bank, now known as the lead underwriter. The lead underwriter will enlist the help of other investment banks, and these banks are known as syndicate banks. Having several banks involved in the underwriting reduces the risk to the lead underwriter and increases public exposure and demand for the new stock. Prior to the new issue, the underwriters will advertise the initial public offering in well-known financial newspapers. This advertisement gives the name of the company going public, the lead underwriter and the syndicate members, and it is known as a tombstone. The banks involved will solicit indications of interest from their respective clients and, based on each bank's allocation of stock, will assign the IPO shares to their clients according to these indications of interest.
While there is no set schedule or amount of time for the underwriting process to take, once a company has entered the red herring stage of an IPO (the final stage before the stock begins trading), the underwriter must bring the stock public within 30 days or the company's prospectus must be rewritten and reprinted, a very expensive process.
Investing in an IPO can be an easy way to make a good return in a short period of time. It is standard practice for underwriters to price the IPO below fair market value so the stock rises in value immediately upon issue, making a nice profit for the initial shareholders. It is for this reason that it is so difficult to get IPO shares. Only the best customers of the underwriters are given these shares, and it is considered one of the financial perks of being an accredited investor.
While initial public offerings are usually managed so that they increase in value upon going public, this doesn't always happen. Especially when an initial public offering is sold on a “best efforts” basis, the IPO may not be fully subscribed prior to trading and may actually drop in value. While the potential is there for initial public offerings to trade at a profit, investors need to realize that there is still risk involved and that they may lose money, even on an IPO.