An initial public offering (IPO) is when a private corporation opens its shares to the public for sale. Though an IPO might sound straightforward in theory, it can be complicated in practice. To help you understand how an IPO works—and determine whether or not it’s the right decision for your company—we’re breaking down the basics below.
In an IPO, a founder sells part or all of their company ownership in order to offer stock to the general public—and potentially raise a huge amount of capital as a result. An IPO gives new investors the opportunity to own a piece of a fast-growing company, and early-stage investors (the ones who were around from the beginning) the chance to sell their shares for a profit.
Why undergo an IPO?
There are a few reasons successful startup founders consider IPOs:
- To raise capital for growth, like funding new research or developing a new product
- To build brand visibility and generate publicity
- To give initial investors a chance to cash in on their investments
- To cede control as a founder and exit the business
Who are IPOs best for?
IPOs aren’t for everyone. Not only is the process of preparing for an IPO rigorous and expensive, but the standards to qualify are incredibly high. Most small and medium-size businesses won’t have the resources or revenue to attempt an IPO, but certain startups and established corporations may have success.
IPOs are best for companies that check the following boxes:
- Experienced tremendous growth in a relatively short period of time
- Attracted the attention of venture capital investors
- Surpassed all or most competitors in a similar market
- Received a recent company valuation at least in the millions
Here are just a few companies that went public in 2021:
- Poshmark, an online marketplace for buying second-hand clothing
- Bumble, a dating app
- The Honest Company, a consumer goods brand
- Clear, a biometrics-based airport security tool
Benefits and drawbacks of an IPO
The appeal of an IPO is that your company has the potential to earn a lot of money—and gain positive publicity along the way. If the IPO goes well and the value of your stock rises, you could earn enough to retire or fund your company’s growth for years to come.
However, going public isn’t an easy process, nor is it guaranteed to be a smooth (or prosperous) transition. There are a lot of regulatory steps to get ready, including registering with the Securities and Exchange Commission (SEC) and undergoing financial audits. The process can take anywhere from six months to a couple of years, plus tons of money in underwriting fees, legal costs, SEC registration fees, and marketing expenses.
And once you go public, there’s always the possibility that the value of your stock goes down, in which case you could lose a significant amount of money.
The process of getting an IPO
There are a few general steps every company has to take to go public.
Step 1: Choose an underwriter
When you go public, you don’t sell your company’s stock yourself. Instead, you hire an underwriter to lead the process. In this case, you’ll choose an investment bank to act as the underwriter. The investment bank helps determine the price of your company’s stock, and agrees to buy your company’s shares and sell them to accredited investors and institutions that invest in the IPO.
When you’re searching for an investment bank, it’s important to consider their level of expertise, track record for working with other corporations, and network. You want to be sure they have experience working in your industry as well as the right connections to sell your shares for a good offering price. Note that “offering price” refers to the price that is set by the investment bank during the IPO process, whereas “opening price” refers to price at which the stock is initially listed on a public stock exchange (the NASDAQ or New York Stock Exchange, for example). We’ll cover the opening price in more detail below, so keep reading.
Step 2: Do your due diligence and fill out documentation
Due diligence is when your underwriters and legal counsel investigate your company’s financials and internal processes to determine the risks of going public. During the process, you and your IPO team will fill out the documentation the SEC requires, as well as sign a series of agreements with your underwriters.
Here are the documents you can expect to address:
- Firm commitment agreement: An agreement that the underwriter will purchase your company’s shares and resell them to the public.
- Best efforts agreement: An agreement that says the underwriter won’t guarantee a certain amount of money, but will do their best when selling the shares on your company’s behalf.
- Engagement letter: A document that spells out the underwriter’s fee and lists any expenses your company will need to cover for them.
- Letter of intent: An agreement stating that both parties intend to cooperate in the IPO process.
- Red herring document: A document that details your company’s operations but doesn’t include information on number of shares or share price.
- S-1 registration statement: A document required by the SEC that gives them a glimpse into your company’s financials.
Step 3: Go on an IPO roadshow
A roadshow is an in-person or virtual tour to market your impending IPO to institutional investors, the people or entities that make big investments on the stock exchange. The purpose of a roadshow is to generate buzz around your company and figure out how much demand there is for your company’s shares.
Step 4: Set the IPO price
After the SEC approves your documents and you figure out how many shares to offer, you’ll work with your underwriters and IPO team to determine the opening price of your shares. The initial price is based on investor demand and your company’s financials.
Step 5: Go public, then adjust to the open market
On the date of the IPO, your underwriter will open the shares to the public. Immediately after, you’ll enter what’s called a quiet period. This is a 25-day period following the IPO where your underwriters have the ability to influence the price of your shares by purchasing and reselling them. Their goal is to stabilize the price of your shares so it doesn’t fall below your IPO price and lower demand.
Once you’re out of the quiet period, your company’s shares will be subject to the ups and downs of the market. Your underwriters can help evaluate your post-IPO earnings, but won’t have the power to intervene on your company’s behalf.
Is an IPO realistic for your company?
To determine whether or not an IPO makes sense for your company, it’s critical to assess multiple different areas of your business. Here are seven critical factors to evaluate:
- Your company’s market potential: Consider how big your particular market is. The larger your market, the greater your opportunity to grow and earn more revenue—and the more likely investors are to take an interest in your company.
- Your offerings: Take an honest assessment of your company’s products or services. To qualify for an IPO, you need to offer something that stands out, but also has the potential to last and evolve over time.
- Your competition: You’ll have more success with an IPO if there’s little to no competition for your products or services, or if you’ve already demonstrated you can overtake your competitors.
- Your company finances: IPOs are expensive; you need enough cash flow to pay for legal and accounting expenses, your underwriter’s commission, marketing costs, and registration fees. Many companies end up spending close to $750,000 or more to be IPO-ready.
- Your company’s growth: One of the biggest indicators of potential IPO success is a high growth rate. Investors want to see that you’re retaining current customers, acquiring new ones, and bringing in increasingly more revenue. Bonus points if your business model is predictable enough to forecast growth and revenue accurately.
- Your company’s resources: Getting ready to go public is a team effort. You need a savvy CFO, a board of directors, enough administrative personnel to oversee the IPO preparation, a marketing team whose sole focus is IPO readiness, and accounting and legal experts to advise you. It’s also crucial to have strong digital infrastructure and effective internal administrative processes in place.
- Your reputation: Getting an IPO forces your company into the spotlight. The public will be able to look at your company finances, share prices, management and hiring practices, and more. You need to be sure you’re ready to deal with a lot of attention and potential scrutiny from investors, media, and the general public.
Going public can be a big win for your company, allowing you to raise incredible capital and propel your growth—if all goes well. However, it’s not a smart move for the majority of companies. If you’re considering an IPO because you need financing or want to prepare for your exit, consult your business accountant and attorney to explore other possibilities and discuss options.