What Is an IPO? Definition and How IPOs Work
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An IPO marks the first time a privately held company becomes a publicly traded one.
IPOs can potentially be lucrative opportunities to buy a small stake in a company you believe will increase in value.
IPOs can be risky too, but thorough research, small investments and smart asset allocation can mitigate those risks.
Thousands of companies sell shares of stock in their businesses on U.S. stock exchanges. How did they snag a spot in investor brokerage accounts? Via a process called “going public,” more formally known as filing for an initial public offering, or IPO.
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IPO meaning
An IPO, or initial public offering, is when a company goes from being privately-owned to publicly-owned. That means that investors can purchase its stock on the stock market.
Those company shares may then be purchased on a particular exchange, like the New York Stock Exchange or the Nasdaq. Investors can then purchase those shares, which makes them a shareholder in the business.
Once a company is listed on a stock exchange, shares of its stock can be traded — bought and sold — between investors. (Learn more about the stock market and how it works.)
How does an IPO work?
An IPO is often a complex process in which a group of "underwriters" (typically large investment banks) buy all of the shares of the new company and then re-sell them to ordinary investors.
However, some companies bypass the conventional IPO process by going public through a direct listing or a special-purpose acquisition company (SPAC).
A company that is going public through an IPO will announce a price range and IPO date in advance. At that time, interested investors will be able to purchase shares through a brokerage account.
Keep in mind that the published offering price is unlikely to be the share price that's available to retail investors — once the stock begins trading, its share price swings with the rest of the market just like every other public company. Often, IPOs spike in price in the early hours or days, then quickly fall.
Where can I find out about upcoming IPOs?
NerdWallet has a list of upcoming IPOs, as do the major stock exchange websites like Nasdaq and NYSE. And there are often rumors published in the media about companies that may go public in the near future, but it’s pure speculation until a company makes a formal announcement of its intentions.
It can be several months, or even years, until an IPO is finalized. To prepare, investment bankers estimate the company’s valuation to decide the price per share of stock and how many shares will be offered to investors.
All of that information and more becomes available to the public when the company files a registration statement — typically a Form S-1 — with the Securities and Exchange Commission. This preliminary prospectus provides a lot of background information about the company and its business, management team, sources of revenue and financial health.
A company’s initial filing is typically a draft and may be missing key information, such as the final offering price and date the upcoming IPO is expected to launch. Keep checking back for amendments to the Form S-1 on the SEC’s EDGAR database so you’re making investment decisions with the most up-to-date IPO information.
Why do companies file IPOs?
An IPO enables a growing company to raise a lot of cash quickly. The money investors pay to buy shares can be used to fund projects, pay down debt and help the business expand operations or hire more workers.
A stock market launch also triggers a broader swath of changes a company must make, not least of which is issuing reports on its financials to the public quarterly and annually and allowing shareholders to vote on some business decisions, such as who sits on the company’s board of directors.
For investors, IPOs can be an attractive and lucrative opportunity to purchase a small stake in a company they believe will increase in value. But buyer beware: Some stocks that are now considered runaway successes struggled for months or even years after their IPOs. Consider that after going public in 2012, Meta (then known as Facebook) took more than a year to trade above its IPO price.
What are the risks of investing in an IPO?
You may celebrate getting in early on the latest IPO if it proves to be a long-term success, but you’ll be cursing that same stock if it blows up your portfolio. No investment is a sure thing, and IPOs are no exception.
While IPOs may appear to offer a tantalizing get-rich-quick opportunity, there have been some famous flops over the years. Take Pets.com, which liquidated less than a year after its IPO. According to an analysis from Nasdaq of IPOs between 2010 and 2020, two-thirds were underperforming the overall market three years after their initial offering day.
To mitigate some of the risks, take the same approach to investing in IPOs as you would to buying any other stock:
Know what you’re getting into. When researching a company, start by reading its annual report — if it has been publicly traded for a while — or Form S-1. Many of the risks to a company’s short- and long-term success are outlined by company insiders in those reports. But don’t just take their word for it: Do your own research into the industry, the company’s competitors and general stock market conditions before you invest in any company. That's a smart thing to do whether the company is established or new to the public markets. (Here’s how to research a stock.)
Ease your way into ownership. Buying a lot of shares of a volatile stock at the beginning can set you up for a wild ride. When a company’s share price is somewhat unpredictable, dollar-cost averaging (spreading out your trades and purchasing the stock at regular intervals over time) protects you from the risk of, say, buying shares at the peak. And keep in mind that you don’t have to be the first in line: Stocks like Apple, Amazon and Google have provided rich gains for investors who bought shares years after those companies' initial public offerings.
Keep your portfolio in balance. Never let a single investment — IPO or otherwise — skew your portfolio’s allocation in a way that could be detrimental to your long-term goals. To reduce your overall risk, it's often suggested that the portion of your holdings devoted to individual stocks make up no more than 5% to 10% of your overall portfolio, with the remainder of your long-term savings spread out across a variety of index mutual funds.
If an IPO is what gets you excited about investing in the stock market for long-term growth, that’s great. Just remember that individual stocks on their own aren’t the only way to get in on the action — there are other diversified investments like the aforementioned index funds that allow you to buy a large selection of stocks at once. To explore these and other options, see our step-by-step guide for beginners on how to invest in stocks.
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