The Advantages of IPOs

An initial public offering (IPO) is selling stock to investors for the first time. The term "IPO" applies to both the process and the stock. An IPO offers several advantages to the company, investors and underwriters -- the investment bankers who do the IPO.

Access to Capital

The main advantage to the company is being able to raise capital for growth. In an IPO, a company typically sells only a small number of shares out of the total number authorized by its charter. Once a stock price is established by the market, and especially if it is rising, a company can sell more shares in a follow-on, or secondary, offering to raise more money later.

Cashing In Early Profits

Company insiders -- founders, top management, key employees and pre-IPO investors such as venture capitalists -- have the opportunity to sell their shares and take profits. Because of the high failure rate among startups, insiders take substantial risks to run or finance new enterprises and do not mind cashing in early.

Lucrative Fees

Underwriters -- investment bankers who take a company public -- charge lucrative fees for their services. Other parties involved, such as the Securities and Exchange Commission that registers the shares and the stock exchange that lists them, also collect fees for their services.

Flipping

In an IPO, a company places its shares with initial investors at the price set by the underwriter, called the "subscription price." Once an IPO starts trading, its share price is set by the market. The initial investors -- the IPO subscribers -- can sell their shares on the market on the first day of trading and pocket the difference between the market and subscription prices -- a process called "flipping." Flipping is a quick and easy way to make instant profits in an IPO if the market price jumps above the subscription price.

Ground-Floor Opportunity

An IPO is retail investors' chance to get in on the ground floor. Buying IPOs is risky: Many IPOs fail or perform poorly, but some go on to become the market's next huge winners, amply compensating investors for the risks. Even IPOs that perform well in the long run may initially decline from their original IPO prices because of market conditions or other factors, trading erratically for the first three to six months -- a process called basing. Some investors prefer to buy shares in 6- to 9-month-old IPOs, when the stock breaks out of its first base to the upside.

References

• "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
• RenaissanceCapital: IPO Home - Why We are Passionate about IPOs