What is an Initial Public Offering (IPO) ?

 

What is an Initial Public Offering (IPO) ?

An IPO, or initial public offering, refers to the method a private company participates in because it offers shares of stock to investors for the primary time. When a company goes through an IPO, we regularly say it's “going public.” 

Learn the ins and outs of the IPO method, what a company needs to do because it prepares to go public, and what IPOs mean for individual investors. 

Definition and Examples of an Initial Public Offering (IPO)

When a company needs to move from private to public ownership, it undertakes an IPO.

The IPO method permits a company to boost cast to fund operations, fuel growth, and pay down debt. An IPO also gives companies the opportunity to pay back its investors, who have the choice of selling their private shares into the IPO. Generally speaking, a private company with appreciable growth potential can think about going public, primarily for the explanations mentioned earlier. In some ways, it’s the logical and expected next step for successful startups. 

One of the more high-profile, recent examples of a company going public is that the story of Airbnb, which went public within the winter of 2020. Airbnb’s IPO prospectus can function a guide throughout the following sections, that detail however an IPO functions and what recent public companies mean for individual investors. 

How an IPO Works

To go public, a private company should register its IPO with the U.S. Securities and Exchange Commission (SEC). Companies generally use Form S-1 to register with the SEC. Inside that S-1, you’ll find the company’s IPO prospectus, that spells out the details of the IPO process. It’s an important document investors must read when considering an investment in a newly public company. 

IPO Terms and Underwriters 

The S-1 lays out the terms of a company’s IPO, particularly focusing on the number of shares it will issue to the public.

As a company prepares to go public, it hires underwriters. These are the financial institutions that receive the shares of the IPO before distributing them to the public. Companies select lead underwriters, who help guide the IPO process and allocate shares. In the case of Airbnb, Morgan Stanley and Goldman Sachs were selected as its lead underwriters.

History, Story, Present Condition, and Risks

Companies use their prospectus to sell potential investors on their IPO. 

As such, the company does a bit of a dance in the IPO prospectus—tooting its own horn and providing a straightforward assessment of challenges it faces and what could go wrong. 

Most S-1 forms look like Airbnb’s, which begins with a look at the company’s history and how it became a viable force in its industry. From there, it outlines the climate the company operates in ahead of its IPO, along with specific financial metrics. 

Here’s an example of how this looks in Airbnb’s prospectus summary: 

In early 2020, as COVID-19 disrupted travel across the world, Airbnb’s business declined significantly. But within two months, our business model started to rebound even with limited international travel, demonstrating its resilience … We believe that the lines between travel and living are blurring, and the global pandemic has accelerated the ability to live anywhere. Our platform has proven adaptable to serve these new ways of traveling … 

We have experienced rapid growth since our founding. In 2019, we generated Gross Booking Value (“GBV”) of $38.0 billion, representing growth of 29% from $29.4 billion in 2018, and revenue of $4.8 billion, representing growth of 32% from $3.7 billion in 2018. During the nine months ended September 30, 2020, our business was materially impacted by the global COVID-19 pandemic, with GBV of $18.0 billion, down 39% year over year and revenue of $2.5 billion, down 32% year over year.

This summary is a great look at what a company must disclose in its S-1. Of course, COVID-19 became a risk for most companies, particularly Airbnb, given that it’s part of the travel industry. 

How Will a Company Use the IPO Proceeds?

The S-1 also includes details on how the company plans to allocate shares to investors, as well as how the company intends to use the capital it receives after going public. 

Here’s part of Airbnb’s description on how it intended to use its IPO proceeds: 

We currently intend to use the net proceeds from this offering for general corporate purposes, including working capital, operating expenses, and capital expenditures. We may also use a portion of the net proceeds to acquire or make investments in businesses, products, offerings, and technologies, although we do not have agreements or commitments for any material acquisitions or investments at this time.

From there, the company provides specifics on its business model, risks it faces, and all of the key metrics it uses to assess its performance. The S-1 gives prospective investors a true look under the hood of a private company as it takes the steps to go public. 

What an IPO Means for the Economy, the Consumer, and the Investor

You may have heard the phrase “hot IPO market.” Generally speaking, this means that the investing public have received companies that go public well. This can cause other private companies to take the plunge into going public. This can also indicate a potentially strong economy, if a significant swath of private companies are doing well enough to increase investors’ appetite for risk. The other way the individual investor can get in on an IPO is by waiting for the shares to hit the market, and purchasing in the following days after it goes public. In this case, an investor can place an order through their broker to purchase shares. However, there may also be a problem with this. 

Let’s say a company’s stock is priced at $10 before it opens to public trading. You only own those shares at a cost basis of $10 per share if your brokerage allocated shares to you at the offering price. Once the shares hit the market, they often fluctuate wildly, opening at a considerably higher price than the offering price. If your brokerage doesn’t allocate those shares to you at the offering price, and you wait a few days after the IPO to buy shares, you’ll likely pay more.

In Airbnb’s case, the stock opened at $146, much higher than the $68 offering price it set just ahead of its debut. By the end of April 2021, Airbnb traded between $170 and $180 per share.

Not all IPOs perform as well as Airbnb’s did from the start. Some hit highs on the first day they go public, but only see downside from there. Simply put, IPOs can be volatile investments with a high risk level, particularly if you must wait to buy shares until they are on the public market.