What is an Initial Public Offering (IPO): Meaning and definition

You might have read about IPOs on various websites, or in newspapers and magazines. Many people may not be familiar with the term IPO and would be wondering what it means and how it works.

One may note that not all IPOs do wonders at the respective stock market exchange of their country. Some also see huge downside after listing. This sends negative sentiment in the companies who plan to launch IPOs.

According to an Ernst & Young report, there were 551 listings worldwide in the first half of 2024, raising $52.2 billion in capital. This represents a 12 percent decline in IPOs and a 16 percent decline in proceeds raised year-over-year. The primary cause of this outcome is the decline in IPO activity in the Asia-Pacific region, with strong increase seen in H1 in the Americas and Europe, the Middle East, India, and Africa (EMEIA).

In this article, we are exploring the real terminology of IPO and its functions in the corporate and financial world.

Definition of IPO

Initial public offering is the expanded form of IPO. It is the procedure by which a privately owned company offers its shares to the public for the first time in order to become a publicly listed firm. A small, privately held company can become public by trading its shares, allowing its owners to share ownership. The company’s name is posted on the stock exchange through the IPO.

Why do companies go for IPOs?

An IPO is commonly used for companies to raise money when they want to expand. The additional funds collected during an IPO is the most significant advantage. The funds that are obtained can be put towards expanding, paying off debt, funding research and development (R&D), purchasing more property, plant and equipment, or any combination of these. An IPO also raises a company’s profile and usually attracts an influx of prospective clients. An IPO can also be used as an exit strategy by venture capitalists, founding partners, and private investors. One of the most popular methods with which venture capitalists raise a sizable sum of money is through an IPO.

IPO process of going public

An organization is regarded as private prior to an IPO. The firm has expanded with a very small number of shareholders as a pre-IPO private company, comprising professional investors like venture capitalists or angel investors as well as early investors like the founders, family and friends. A company’s ability to raise large sums of money through an IPO makes it a significant milestone. As a result, the business has more potential to develop and flourish. Improved transparency and the legitimacy of the share listing can also help it get favorable terms when looking for loans.

A firm will start to publicize its interest in going public when it reaches a point in its development where it feels ready for the demands of regulatory rules, as well as the advantages and obligations to public shareholders. This phase of expansion usually happens when a business achieves unicorn status, or a private valuation of about $1 billion. However, depending on market competition and their capacity to fulfil listing standards, private firms at different valuations with solid fundamentals and shown profitability potential can also be eligible for an IPO.

A company’s IPO shares are valued through underwriting due diligence. A company’s previously held private share ownership changes to public ownership upon becoming public, and the value of the shares held by current private shareholders is determined by the public market price. Special arrangements for private to public share ownership can also be included in share underwriting. Millions of investors, meanwhile, have a fantastic chance to purchase firm shares and add money to the shareholders’ equity of a business through the public market. Any individual or institutional investor interested in making a financial investment in the firm is considered part of the public.

Steps to an IPO

Here are steps in the IPO going public:

1. Proposals: The best kind of security to issue, the offering price, the number of shares, and the anticipated time period for the market offering are all covered by the proposals and valuations that underwriters submit.

2. Underwriter: Through an underwriting agreement, the corporation formally agrees to underwrite terms and selects its underwriters.

3. Group: Teams of underwriters, attorneys, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) specialists are assembled for IPOs.

4. Documentation: Data about the business is gathered for the necessary IPO paperwork.

5. Marketing and updates: For the new stock issuance’s pre-marketing, marketing materials are produced. To determine a final offering price and assess demand, management and underwriters publicize the share issue. During the marketing phase, underwriters might make changes to their financial analysis. This may entail adjusting the IPO price or the issue date based on their judgement.

6. Board and procedures: Establish a board of directors and make sure that procedures are followed for quarterly reporting of auditable financial and accounting data.

7. Issued shares: On the day of the IPO, the firm issues its shares. Cash is received by shareholders as capital from the main issuance, and this equity is shown as stockholders’ equity on the balance sheet. As a result, the whole valuation of the company’s shareholders’ equity per share affects the value of the shares on the balance sheet.

8. Post IPO: There could be certain post-IPO regulations implemented. Following the day of the IPO, underwriters could have a particular amount of time in which to purchase further shares. Certain investors could have calm times in the interim.

Read more | Saudi Arabia expects over 50 IPO listings this year: Saudi Exchange CEO

Benefits and risks of IPO

There are several benefits and risks associated with an IPO, below are some interesting points:

Benefits

1. Unlike loans provided by banks and other financial organizations, there is no requirement for a repayment term.
2. Interest on the money raised is not required to be paid.
3. Debts from the past can be settled using the money generated.
4. When a firm files for an IPO, its profile grows. Its products and services are also thoroughly examined, given that the shares are listed on a public exchange. This frequently results in effective brand development and increased product market share.
5. IPOs provide a way out for investors. After selling off their investment in a company, a number of venture capitalists have left the company. Following an IPO, the prices of the shares frequently soar once they are placed on a public exchange. Therefore, when they choose to sell, the promoters and investors might get wealthy.
6. A firm is subject to a set of regulations if it goes public. This structure aids in preventing fraud. A corporation that implements these procedures may see a significant increase in transparency in its accounting procedures. Long-term business benefits might result from this transparency.

Risks

1. Since there is no previous performance data available, investing in IPOs carries a huge risk. IPOs don’t have access to this vital data, unlike well-established public firms that have a history of market behavior and financial performance.
2. It involves a great deal of market turbulence and unpredictability, especially in the early trading window after their release. Significant price fluctuations that are influenced by a number of variables, such as investor enthusiasm, market mood, and current market conditions.
3. Compared to well-established public corporations, businesses undergoing an IPO could reveal less information. To evaluate the investment possibilities, you might need to rely on the company’s management estimates and industry research because the material in IPO prospectuses is sometimes minimal.
4. Company insiders and early investors typically face lock-up periods following an IPO, during which they are prohibited from selling their shares. There may be an increase in the supply of shares once the lock-up period ends, which might cause the share price to decline.
5. Not every IPO does successfully in the marketplace. Some businesses struggle to carry out their business goals or fall short of investors’ expectations. Purchasing an underperforming IPO may incur losses or yield lower returns than the actual investment.
6. Institutional investors and major brokerage firms frequently have first access to IPO shares, leaving ordinary investors with limited possibilities. Due to this allocation bias, individual investors may be allocated shares at higher prices during aftermarket trading or may lose out on well-liked IPOs.

IPO case study

Facebook, founded by Mark Zuckerberg, filed its S-1 form with the Securities and Exchange Commission in January 2012. The S-1 form is the document that a non-listed firm has to prepare for an IPO. And, it is needed by the aforementioned responsible authorities. Numerous news stories explored the reasons behind this surprising decision. However, in reality, there was just one: the primary driver was a 1964 SEC regulation that was out of date. It was obviously impractical for a large corporation like Facebook to comply with this law, which mandates that a firm with more than 500 shareholders must follow financial disclosure guidelines that are the same as those given to a stock market listed company, without going public.

Facebook was aware of this restriction and made every effort to circumvent it. For instance, when it received $450 million from Goldman Sachs in 2011, it requested that the financial firm arrange the transaction such that all of the new owners would be counted as one.

Due to the selling of shares by several early investors in private markets, Facebook crossed the 500 shareholder threshold. This was made possible by the company’s remarkable development over the years, which increased Facebook’s demand. The largest social network in the world was about to go public. It was marking one of the largest IPO in U.S. history. This actually sparked rivalry on Wall Street.

Valuation and price targets

Facebook analysts thought to a value around $30 for the initial price. But in the days before the IPO, the demand was high: many people, observing the IPOs of other internet companies such as Google or Linkedin, were seriously interested in gaining through this relatively new investment sector, so at the end the price for the IPO was set at the highest level of the range found during the roadshow, $38.

Listing day and following days

The U.S. stock market opened for regular business as normal at 9.30 a.m. on Friday, May 18, 2012. Due to a technical issue, Nasdaq notified investors that day that trading for the Facebook IPO would begin at 11:30 AM. IPOs listed on the Nasdaq are typically traded at least an hour after they are listed. At the predetermined price of $38, Facebook shares were finally traded under the ticker symbol FB. In less than 30 seconds, more than 80 million shares were exchanged. The stock quickly increased in value to $42. However, it struggled to remain above the IPO price on the first day, despite the first impact. The Nasdaq concluded the sale of Facebook shares at $38.23 at 4 p.m., the closing bell, only 0.6 percent higher than the opening price.

Frequently Asked Questions (FAQs)

What is the meaning of an IPO?

A private firm can become a publicly listed corporation by first offering its shares to the public through an initial public offering (IPO).

What are the risks of investing in IPOs?

There are a number of risks associated with investing in IPOs. These are like the absence of past performance data, market volatility and unpredictability. Also, a lack of information and transparency, lock-up periods, underperformance, and allocation biases.

Is investing in an IPO a wise move?

Purchasing an IPO may turn out to be a wise choice. Investing early in a stock that has significant upside potential might pay off in the long run as the stock’s value increases.

How can an investor manage the risk while planning to invest in IPO?

Investors should study the company’s future, conduct in-depth research, and consider speaking with financial experts in order to reduce risks. The impact of any individual IPO investment can also be lessened via diversification and a long-term outlook.

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