An initial public offering (IPO) is when a private company becomes a public company by opening its shares to the public for sale on the stock market. Though an IPO might sound straightforward in theory, it can be complicated in practice. We’re breaking down the basics below to help you understand how an IPO works—and determine whether or not it’s the right decision for your company.
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IPO basics
In an IPO, a founder sells part or all of their company ownership to offer stock to the general public and potentially raise a huge amount of capital as a result. Until now, the company has only had private investors. An IPO allows new investors 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. There are three stages for an IPO life cycle: pre-IPO, IPO (the transaction stage), and post-IPO.
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-sized 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
The last several years have seen some headline-making IPOs. There was Airbnb’s IPO in December 2020, which was followed by a banner year for IPOs. In 2021, the IPO market was hot, with 1,035 IPOs, a whopping number and the most IPOs in a single year. Some of the IPOs from that year included:
- 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 a traditional IPO
There are several steps to go public for the first time, from pre-IPO preparations to post-IPO compliance. Below are the 6 steps you’ll take for a successful IPO.
Step 1: Choose an underwriter
When you go public, you don’t sell your company’s stock yourself. Instead, you hire an investment bank to act as the underwriter. The investment bank helps determine the price of your 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, 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 for your IPO shares.
Note that “offering price” refers to the price that is set by the investment bank during the IPO process, whereas “opening price” refers to the price at which the stock is initially listed on a public stock exchange (the NASDAQ or New York Stock Exchange (NYSE), for example).
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 and 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 the 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: SEC review
At this point, the SEC will review your financial statements and other documentation submitted during the registration. They may provide comments or requests for clarification, which the company and its underwriters must address by filing amendments to the preliminary prospectus. Keep in mind that these disclosures don’t conclude being reviewed by the SEC. You’ll need to participate in ongoing financial reporting.
Emerging growth companies with less than $1 billion in revenue will remain in that category after going public until they exceed that growth milestone or reach other thresholds. That means they can hold off on implementing certain accounting policies. They also don’t have to have their internal controls annually reviewed by an external auditor, though their management team will need to evaluate them. Smaller reporting companies are exempt, and other public companies have up to two years after they IPO for that to take place.
Regardless of when your company could be up for review, you want to prepare yourself for SOX compliance and the regulatory requirements that entails before you even file for IPO. (SOX stands for the Sarbanes-Oxley Act of 2002.) So make this a priority on your IPO readiness checklist to secure your place among other successful public companies.
Step 4: Go on an IPO roadshow
A roadshow is an in-person or virtual tour to promote your IPO prior to shares being sold to the public. This is where your equity story can shine, which should weave a captivating narrative of your vision and business strategy, including value proposition, differentiators, growth prospects, cost management strategies, and more. The purpose of a roadshow is to generate buzz around your company and determine the demand for your company’s shares among these groups:
- Institutional investors: large entities like mutual funds and pension funds that invest money on behalf of others
- Retail investors: individuals who buy and sell securities for their personal accounts, typically investing smaller amounts
The underwriter will bring a draft prospectus on the roadshow to present to potential investors. They will participate in the IPO through their brokerage firm.
The IPO stock price will depend on the orders received from early investors during the roadshow. This is known as the book-building process.
Step 5: 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 6: Go public
On the date of the IPO, your underwriter will open the shares to the public. Immediately after, you’ll enter a lock-up period and a quiet period. The lock-up period is a predetermined duration after an IPO, during which insiders, such as company executives and early investors, are restricted from selling their shares on the public market.
The quiet period is a 40-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.
Step 7: Adjust to the open market
Once you’re out of the quiet period, your company’s shares will begin trading in the capital markets and be subject to the market’s ups and downs. Your underwriters can help evaluate your post-IPO earnings but will not have the power to intervene on your company’s behalf.
Alternatives to a traditional IPO
There are many reasons to take a company public, but depending on your goals, there are alternatives that could be a better fit. Let’s review them:
Direct listing
In a direct listing, a company makes its shares available for trading on a public stock exchange without using underwriters or issuing new shares. This allows existing shareholders, including employees and early investors, to sell their shares directly to the public.
Merger or acquisition
Companies may choose to merge with or be acquired to access additional capital, achieve liquidity for shareholders, or accelerate growth. Mergers and acquisitions can provide immediate access to capital without public investors.
You can merge with an existing company or a publicly-held shell company, also known as a corporate shell or a Special Purpose Acquisition Company (SPAC).
Crowdfunding
Crowdfunding platforms allow companies to raise capital from many individual investors, often through online platforms. This method is particularly popular for startups and small businesses seeking early-stage funding.
Private equity
High-net worth individuals or firms that manage funds for a limited number of accredited investors provide an infusion of capital in exchange for ownership in a private company. This can provide the funds needed for long-term growth, though private equity investors often purchase a controlling interest in businesses.
Is an IPO realistic for your company?
To determine whether or not an IPO makes sense for your company, it’s critical to conduct an IPO readiness assessment to closely analyze, prepare, and improve different areas of your business. You should be budgeting to hire an experienced firm to assist with this. 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 nearly a million dollars 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 and finance team, a board of directors, enough administrative personnel to oversee the IPO preparation, and a marketing team whose sole focus is IPO readiness. These are in addition to technical accounting and legal experts to advise you on a broad range of needs, including developing a sound roadmap and adopting strong corporate governance to balance shareholder and stakeholder interests, among other requirements. It’s also crucial to have a 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 the right 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.
