What is an IPO and how does it work?

An IPO, or initial public offering, is the first time a company lists on the stock exchange. It is essentially how shares in a company become available to buy on the stock market. Discover more about how IPOs work, and how you can invest in one, below.

Connor Campbell Published on 26 August 2021.
What is an IPO and how does it work?

Shares in a company usually are not readily available to buy until that company goes through an IPO.

But what is an IPO?

It is the process in which a company lists on the stock exchange and issues shares that the general public can buy. In other words, it is how a company becomes part of the stock market.

» MORE: What is the stock market?

Read on to find out more about how IPOs work and how you can invest in a company that has had one.

What does IPO stand for?

IPO stands for initial public offering. An initial public offering is the first time a company’s shares are listed on a stock exchange.

It is also sometimes called ‘floating’ on the stock market, or ‘going public’. However, the latter term is slightly misleading – a company can sometimes be ‘public’, without being listed on a stock exchange.

» MORE: What is a public limited company?

From the perspective of a company, it is a way to raise a significant amount of capital by selling shares – i.e. portions of the company – to investors. It also carries with it a certain amount of prestige and can often represent the next step in a firm’s growth plans.

The number of shares issued, and the price they are selling for, determines a company’s market capitalization.

» MORE: What is market cap and why does it matter?

For investors, meanwhile, an IPO is the moment a company’s shares become widely and easily available to trade through a variety of different tools, such as brokerage accounts or stocks and shares ISAs.

Shares are first available on the primary market, which is where they are issued, before becoming tradable on the secondary market, where they are freely bought and sold between both retail and institutional investors.

Retail investors are individual investors acting on their own behalf, for example buying shares through a brokerage account, while institutional investors, such as hedge funds and pension funds, pool money from multiple people and invest it for them. Institutional investors typically work on a much larger scale than retail investors.

How does an IPO work?

There are a number of steps to an initial public offering before it gets to the point when investors can buy shares.

1. Choosing an investment bank

To start the IPO process, a company will need to appoint different advisers – the most important being an investment bank.

The investment bank will not only advise the company on the IPO but also underwrite the initial public offering itself.

In the context of an IPO, an underwriter guarantees it will sell a certain number of shares in a company for a fee and promises to buy any stock that hasn’t been bought.

Underwriting involves the bank:

  • Looking for investors to subscribe to the IPO, often as part of a formal roadshow.
  • Helping to set the offering price and number of shares of the IPO after assessing the risk and level of interest.
  • Facilitating the sale of shares to those investors who subscribed to the IPO.
  • In some cases, ‘stabilising’ the price of the stock once the IPO has launched.

2. Registering on a stock exchange

A company would also need to decide which stock exchange to list on. Each exchange – for example, the London Stock Exchange (LSE) or New York Stock Exchange (NYSE) – has its own requirements and listing fees.

As well as this, they will each have their own benefits, such as varying levels of exposure and access to capital.

Then the company will have to submit a registration statement to the commission in charge of the exchange.

For the London Stock Exchange that is the Financial Conduct Authority (FCA), while for the NYSE it is the Securities and Exchange Commission (SEC).

3. The day of the IPO

Once the application has been approved, an offering price has been agreed and investors have subscribed, it is time for the actual IPO. This will take place on a pre-set date.

At the discretion of the underwriter, investors subscribed to the IPO will buy their allocated number of shares at the final offering price agreed. This will happen before the stock exchange has opened, on the primary market.

After the opening bell has rung on the stock exchange, however, a company’s shares will not immediately be available.

Before that can happen, the exchange will receive and record offers to buy and sell shares in the company from the secondary market – what most people would understand as the stock market. This is in order to set an opening price with the help of a designated market maker.

This is why there can be a difference between a company’s offering price and its opening price. The latter is dictated by the supply and demand on the secondary market.

Although it is not always the case, IPOs tend to do very well, or ‘pop’ on their debut. For example, between 1980 and 2020, the average first-day return on a stock launching on the NASDAQ was 18.4%.

Alternatives to an IPO

While it is the most common option, an IPO is not the only way a company can become a tradable entity on the stock market.

Direct listing

If a company has already secured multiple rounds of private financing, it may not feel the need to raise extra capital through an IPO.

In this case, a company can list on a stock exchange – and therefore become widely tradable – through a direct listing.

By doing so, the company would avoid many of the fees and conditions required for an initial public offering.

The company’s opening price would then be wholly determined by demand from the secondary market.

SPAC

A SPAC, or special purpose acquisition company, has become an increasingly popular method of floating on the stock market.

This is where a shell company, normally formed by private equity firms or venture capitalists, goes through an expedited IPO process, with the future aim of merging with an unlisted company.

This allows the acquired company to debut on the stock market without incurring the cost of the IPO itself and gives it quicker access to capital that has already been raised.

SPACs will often be created without a specific acquisition in mind, meaning anyone who invests in a SPAC is taking a risk on the eventual acquisition.

At the same time, it is a way for retail investors to access IPOs that traditionally would have been the preserve of institutional investors.

What is an example of an initial public offering?

There are normally hundreds of IPOs a year, from all over the world. However, some attract far greater attention than others and can act as extreme examples of the benefits and potential pitfalls of floating on the stock market.

It is also worth noting that the success or failure of a stock on its IPO will not necessarily reflect its long-term market performance.

Beyond Meat IPO investors hungry for debut

One of the biggest IPO ‘pops’ of the 21st century came when plant-based meat manufacturer Beyond Meat Inc. listed on the NASDAQ stock exchange on 2 May 2019.

The company’s initial offering price was $25 per share, implying a market cap of $1.46 billion.

When it came to the secondary market, Beyond Meat’s opening price hit $46.

Eventually, Beyond Meat closed its first day of trading at $65.75 – 163% higher than its initial offering price.

Deliveroo IPO ‘the worst IPO in London’s history’

At the other end of the spectrum was the debut of British food delivery service Deliveroo PLC.

After years of private funding, Deliveroo announced it would be listing on the London Stock Exchange on 31 March 2021.

Due to what it called ‘volatile’ market conditions, Deliveroo set its offer price at a lower than forecast 390p per share. This would have given the company a market cap of around £7.59 billion.

However, when shares became available the stock plunged as much as 30%. Deliveroo eventually closed its first session at 287.45p per share – a 26.3% reduction on its offer price.

So disastrous was this debut, that a banker involved in the launch labelled it “the worst IPO in London’s history”.

How to invest in an IPO

Although IPOs are dominated by institutional investors, retail investors can still participate in an IPO, either on the primary or secondary market.

On the primary market

Previously, restrictions were placed on IPOs that meant only institutional investors could fully engage with an initial public offering.

However, it is now possible for retail investors to get involved with an IPO on the primary market.

To do so, you will first need a share dealing account with a broker that has partnered with a service offering IPO allocation to individual investors.

Then you need to ‘subscribe’ to your chosen upcoming IPO to indicate your interest in buying shares once they are listed.

On the secondary market

The easier way to invest in an IPO is to buy shares of a company as soon as they are available on the secondary market.

This could be via your share dealing brokerage account or through a stocks and shares ISA.

You should be aware of the early volatility associated with shares of companies launching on the stock market and the potential difference between the offer price and the eventual opening price.

Keep an eye on the various IPO calendars online to make sure you are up to date on which companies have upcoming IPOs.

» MORE: How to get started investing

WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.

Image source: Getty Images

About the author:

Connor is a writer and spokesperson for NerdWallet. Previously at Spreadex, his market commentary has been quoted in the likes of the BBC, The Guardian, Evening Standard, Reuters and The Independent. Read more

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