Around 4,000 companies sell shares in their businesses on U.S. stock exchanges, according to data from the World Federation of Exchanges. How did they snag a spot on the investing menu? Via a process called “going public,” more formally known as filing for an initial public offering, or IPO.
Definition: What is an IPO?
An IPO is Wall Street’s version of a launch party. It marks the first time a privately held company becomes a publicly traded one.
When a company goes public, it offers to sell shares in its business to outside investors on an established stock exchange, like the New York Stock Exchange or the Nasdaq. Investors can then purchase those shares, which makes them a part owner of 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.)
Where can I find out about upcoming IPOs?
NerdWallet has a list of upcoming IPOs and an IPO calendar, 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 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.
How do I invest in an IPO?
Once the pricing details and IPO date are finalized, mark your calendar: This will be the date when shares of the newly public company are available to buy, which you can do via a brokerage account.
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The mechanics of purchasing shares in an IPO are pretty straightforward. Here’s a brief guide to how to buy stocks, including information on how to navigate your broker’s website and place an order.
But this is where IPOs can be deceptive. There’s a difference between an IPO offering price and the price you’ll pay for the stock. The offering price announced ahead of the IPO is a fixed price reserved for a limited group of investors, including the company’s employees and investors who satisfy certain eligibility requirements (such as a minimum asset balance or how frequently they trade).
Their orders are filled before the opening bell rings on IPO day. To entice investors, the IPO price is typically lower than what analysts pricing the company believe the shares can fetch on the open market.
The price you pay for an IPO the day it debuts could differ dramatically from the initial offering price.
For most investors, investing in an IPO means buying the stock once it begins trading. That means the price you pay will reflect the demand for the stock on the day it debuts and could differ dramatically from the offering price. And opening-day hype only adds to the price volatility and the argument for taking a wait-and-see approach to IPO investing.
IPOs can spike higher and plummet quickly in the early days of being publicly traded. Consider Snap, the parent company of Snapchat that went public in 2017 with an IPO price of $17. It jumped more than 40% on its first day of trading, but in the past year has traded between $5 and $15 a share.
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.
IPOs can be an attractive and lucrative opportunity to purchase a small stake in a company they believe will increase in value.
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, 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, or Groupon, which has yet to see its stock anywhere near the level at which it debuted.
According to an analysis from investment bank UBS, of the more than 7,000 companies that had IPOs between 1975 and 2011, about 60% had negative total returns after five years of being publicly traded.
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, we recommend 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.