It’s every tech bro’s dream: “I’m gonna be rich when my start-up has it’s IPO”. Many founders eagerly await the day their company has its IPO. Robinhood is about to do it. AirBnB is scheduled to do it. But WTF is an IPO?
IPO stands for “Initial Public Offering”. When a company offers shares of its ownership to the public for the first time, it has its IPO. Before an IPO, a company is considered private. Afterwards, it is a public company that can be traded by pretty much anyone through a stock exchange.
Testing… Testing… 1, 2, 3
Every stock exchange has a process for listing new stocks on their exchange. Companies that want to IPO undergo tough due diligence. This testing is to make sure they meet business standards. All public companies are required to report their financial statements and accounting documents every quarter. If a potential IPO does not have their shtuff in order from the get-go, the exchange will not allow them to become a public company. This is one of the measures taken to protect public investors’ (that’s you and me) interests.
During due diligence, the company enlists at least one investment bank to value the company and assign a price for the shares. This process is called underwriting. (I know it might sound like tech bros and finance bros working together would be a social nightmare, but this is an important step.)
Just like many banks require a home to be inspected and appraised before they will allow someone to take out a mortgage, companies looking to IPO need to be inspected and appraised before being released to the public. The underwriting process attempts to price what the company is worth now and what their future growth reasonably looks like. It’s a chance for experts to really dig into the business. They’re looking to uncover any skeletons the company might be trying to hide in the janitor’s closet. Again: to protect investor’s interests. The goal of underwriting is to price high enough that the the company gets the most money without having investors pay too much.
All of this work does not come cheap. A company needs to be pretty confident in its worth before they decide to go down the IPO path. It’s why you often hear about companies before they release their shares to the public. They have to be big enough to make an impact — big enough for outside investors to want to own a piece of the company — before they IPO.
The most reason a company’s founders want to IPO is that many start-up executives and early employees are granted shares of stock as part of their compensation package. Often in place of cash-money wages. It’s a cheap way for young companies to entice talented workers to take a risk: the payoff if their company IPOs and they can sell their shares can be huge.
Without an IPO, there aren’t many people who can buy the shares off of those employees. Think of it this way: you can give yourself as many shares of something as you want. But unless other people think your shares have value, those shares are worthless to everyone. Founders want the IPO to confirm their wealth. Even if founders don’t sell their shares at the IPO, they still have a publicly-verified count of how much all their shares are worth. That’ll definitely help them score with the babes.
What’s in it for You?
For investors, IPOs allow people outside a company to participate in its growth. It is crucial that prospective investors take a look under the hood for themselves, though, and decide whether the company is a good investment. There are lots of organizations that do cool things or have great marketing. But if their management doesn’t have it together, the company will fail. When a company fails is when investors lose money. Not what you want. Because financial analysts don’t have a full history of an IPOing company, it’s difficult to tell where the stock price is going to move. Oftentimes, it’s a safer bet to wait until the hype dies down before buying shares in a brand new company.
I hope this helps you understand what an IPO is and why it’s important.