Stocks · Beginner · 5 min

How companies go public (IPO)

You can describe the steps of an IPO, what the prospectus and the lock-up period are, and why IPO shares are risky for private investors.

Going public

Every company on a stock exchange was once private, owned by its founders, employees and a few investors. At some point it decides to sell shares to the public for the first time. That is its initial public offering, or IPO.

IPO days come with headlines, ringing bells and big price moves. For private investors they are also some of the riskiest days to buy. This lesson explains how an IPO works and what to look at before getting excited.

From private to listed

In an IPO, a company offers its shares to the public for the first time and lists them on an exchange. It usually raises new money this way, and early owners may sell part of their stake.

Steps The steps of an IPO: a private company hires underwriters, publishes a prospectus, sets an offer price and starts trading on an exchange. 1 Private company 2 Underwriters 3 Prospectus 4 Offer price 5 First trade

The usual steps:

  1. Underwriters. The company hires investment banks, which organize the offer and often buy the shares from the company to resell them.
  2. Prospectus. A prospectus describes the business, the finances, the management, the risks and the terms of the offer. In the US it is filed with the SEC. The SEC stresses that this is not an approval of the investment's merits.
  3. Offer price. The banks collect interest from investors and set the price. They also decide who gets shares at that price, mostly large investors.
  4. First trade. The shares begin trading. The SEC notes that underwriters may support the price in the first days, for example by buying shares.

After the IPO, insiders usually agree not to sell for a while. This lock-up period often lasts 180 days, according to Investor.gov. When it ends, many shares can reach the market at once, and the SEC warns that the price may fall significantly.

There are other routes to the market. In a direct listing, existing shareholders sell directly on the exchange, usually without new money being raised. A SPAC is a listed shell company that raises money first and then merges with a private company.

Hype, then lock-up

A fictional company sets its offer price at 20. Demand is strong.

The large investors who received shares at 20 are still ahead. The private investor who bought the hype is down 800, about 27%. Nothing about the company changed in those six months. What changed was the balance of buyers and sellers: the early excitement faded, and new supply arrived on a date that was printed in the prospectus from the start.

Common mistakes

The takeaway

In an IPO, a company sells shares to the public for the first time. Read the prospectus, expect wild first days and mind the lock-up.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

  1. 1Tap the document that describes the company, the risks and the terms of the offer.

    Tap the chart.

    Steps Chart for the question: Tap the document that describes the company, the risks and the terms of the offer. 1 Private company 2 Underwriters 3 Prospectus 4 Offer price 5 First trade

    The prospectus is the key document of an IPO. The SEC stresses that its approval is not an endorsement of the investment.

  2. 2What is a lock-up period?

    Investor.gov notes that most lock-ups last 180 days. When they end, many shares can come to market at once.

  3. 3Does the SEC's review of a prospectus mean the IPO is a good investment?

    The SEC checks disclosure, not quality. Judging the investment remains your job.

  4. 4A share is priced at 20 in the IPO and opens at 30. A private investor buys at 30. What happened?

    Shares at the offer price usually go to the investors the underwriters allocate them to. Others buy in the market, at whatever price it trades.

of 4 correct.

Sources