Before I started out investing in the stock market and I’m still on the process of learning the basics, I came across several news articles announcing that a particular company is opening up an IPO. So I wondered what an IPO is and how is it relevant to investors. In this article, I will discuss in the simplest terms the definition of IPO, how it works, and if it is a good investment.

What is an IPO?

All companies, regardless of their size, have to start somewhere. Usually, the founders are the ones who invest a huge amount with the hopes of seeing their business grow eventually. However, as small- to medium-sized companies begin to gain traction, they realize that they also need financing from outside parties for their business to continue to grow. This is where IPO comes in—when companies decide to go public.

IPO stands for Initial Public Offering, and it refers to the process in which a private company becomes a public company by starting to sell stock to outside investors. By selling shares while ensuring compliance to the reporting guidelines set by the Securities and Exchange Commission (SEC), the company will be able to raise more capital and continue to grow.

How do IPOs Work?

A IPO can be a lengthy process. Initially, what happens is that the company hires an investment bank (or several investment banks) to come in and underwrite the IPO. The chosen bank/s will then put up a particular amount of money to fund the IPO and buy the shares before actually being listed on a public exchange. So how does this benefit the investment bank? Basically, the bank will earn profits because they will pay less per share compared to what they actually sell the shares for publicly.

Next, for the IPO to move to the next stage, a registration statement must be filed with the SEC. This document includes all important information about the company including ownership and financial details. When the IPO is approved with the SEC, a date will be set.

The underwriter will have to put forth a document summarizing the company’s finances—this is called a prospectus. In addition, the underwriter will collaborate with the company to establish an initial stock price for when the company’s shares are made available to outside investors.

Why Do Companies Choose to Go Public?

The main benefit of launching an IPO and go public is to gain access to more capital from outside investors. This capital can then be used to expand the business, fund the research and development or marketing, and whatever the issuing company needs in order to grow the business and make more profits.

However the catch is that when a privately-held company becomes a public company through IPO, it will be required to comply with the strict reporting guidelines of the SEC. This includes putting out regular disclosure statements and sharing financial information publicly. Also, the company will have to answer to its shareholders. Hence, the core management will lose some control in exchange for the additional capital provided by the investors. Despite all this, it is usually a reasonable trade-off for companies to make.

Are IPOs Attractive Investment Opportunities?

While IPOs are beneficial for the companies that are going public, they are not at all times great investment opportunities for investors, particularly for those who are inexperienced.

It’s true that investing in IPOs can be highly profitable. However, it can involve a much greater risk compared to when you invest in established companies that already have a long history of stellar performance.

Although there are surely some exceptions, IPO stocks generally tend to underperform for a couple of years after being issued to the public. The reason behind this is that these companies who just launched an IPO are more focused on growing the business rather than delivering returns to their investors. If you are inclined to invest in IPO stocks, make sure that you take the time to examine the company before pushing through with your plan.

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