Question mark icon with text, IPO.

If you heard someone talking about a unicorn undergoing an IPO, you might think it was gibberish at first. But on Wall Street these days, it’s not a fantasy phenomenon — it’s a real situation.

Read on for answers to all your questions from “What is an IPO?” to “What does a unicorn have to do with the stock exchange?”

What is an IPO?

An IPO stands for initial public offering. It’s the process a private company goes through when it first begins to offer shares of its stock to the public. This process is referred to as “going public.”

What is the difference between a public and private company?

Prior to an IPO, a company is private. This means all of its funding comes from a small group (or groups) of private investors. Typically, early investors may be friends and family of the company’s founders. Other shareholders might include venture capitalists or angel investors, both of which are professional investors that provide funding for small companies, startups, or entrepreneurs.

When a company undergoes an IPO, it is allowed to sell shares of its stock to retail investors. This means most public investors, with certain exceptions, can become shareholders in the company IPOs and also give companies the ability to raise capital.

How does an IPO work?

Not every private company is eligible for an IPO. To qualify, a company must meet U.S. Securities and Exchange Commission (SEC) regulations and requirements.

When a company decides it’s ready to go public, it must choose an underwriter to lead the process. Interested investment banks will submit bids to the company, and it can choose one or multiple underwriters to manage different aspects of the IPO. (Basically, the investment bank that is selected will fund the IPO by buying the shares itself before they are made available to the public in the market.)

Once chosen, the company and bank(s) will create an underwriting agreement that details things like what kinds of securities will be issued and how much money will be raised.

Due diligence is next in the pre-IPO process, which is how IPO share prices are determined. To perform this work, an IPO team must be formed. This includes the underwriters, lawyers, accountants, SEC experts, and investor relations and public relations pros. The IPO team works together to collect all the financial information needed.

Next, the investment bank must file the Form S-1, or Registration Statement, with the SEC. This document includes the prospectus (which may be referred to as a “red herring prospectus,” if it’s a preliminary version before the registration statement is effective) and the privately held filing information. Details like the company’s financial statements, legal and management background, business model, competition, and more are included. Plus, it documents how the raised capital is to be used and who currently owns shares of the private company.

A business must take several additional steps to prepare for an upcoming IPO, which can include forming a board of directors, auditing its financials, and joining the stock exchange on which it will be listed. Then, they must announce the initial public offering through a press release. At the end of a months’ long process of preparation, the company will then issue shares to buyers on its IPO date.

Why do companies go public?

The objective of an initial public offering is for the issuing company to raise capital by getting access to the public investment market, rather than just raising money through private investors or loans. IPOs can also significantly increase the value of early investments in the company. Other advantages of going public are heightened exposure and prestige, plus greater potential to be acquired or merge with another company, to name a few.

Of course, going public is a lengthy (and expensive) process. Plus, public companies must be extremely transparent with their financials and adhere to strict SEC guidelines. Management may also lose some control to shareholders and the board of directors. For these reasons, among others, an IPO may not be worth the time and effort for all companies.

Investing in IPOs

Investing in an IPO may sound like a good way to get in on a hot new company and make a lot of money because of its anticipated skyrocketing share price. Because the IPO process requires a significant amount of time, vetting, and analysis, a company that enters the open market typically is seen to have potential for growth. But like all investing, risk is involved and a loss of some or all principal invested may result. It’s important to do your research before jumping in full steam ahead.

If you’re thinking about investing in an IPO, you first need to identify a company that is preparing for one. You can find IPO activity by searching filed S-1 Registration Statements with the SEC. You’ll also need to open an account with a brokerage firm that participates in IPOs. Note that many brokerage firms have requirements (like investment account minimums) you must meet in order to qualify for participating in an IPO.

If you’re eligible to participate in an IPO through your brokerage, it’s a good idea to learn as much about the upcoming IPO and company as you can. While you can follow news headlines, the best way to gain an understanding about the issuing company is by reading the prospectus. In it, you will find information about the investment bank that is underwriting the IPO, the management team behind the company, and specifics of the offering.


 

Potential IPO Benefits

When you invest in an IPO, some call it getting in on the “ground floor” of a company. In other words, you could get access to a business with major growth potential — meaning there’s a possibility for significant earnings for you, especially if you hold your equities long-term.

Another potential benefit of investing in an IPO is the level of transparency. You’ll be able to view how the IPO shares were priced — access that is lost once a company is public as prices fluctuate based on the market.

Potential IPO Risks

Like investing in any stock, investing in IPOs comes with risk attached. You can’t reference any data on the stock’s past performance because the company is new to the market and that information simply doesn’t exist. And while you shouldn’t always rely on historical performance to predict the future, the lack of a company’s stock history means you may not fully understand what you’re getting into.

Investing in an IPO can mean you may be able to acquire shares at a relatively low prices. But in some instances, an IPO will stir up a lot of market hype and the stock price could already be sky high.  If you end up buying at a premium, you may lose a significant part of your investment as the stock’s price may adjust downward once the initial hype dies down.

When the coolest new delivery app, Instagram fashion brand, or software startup companies decide to go public, it’s normal for the market (and the media) to get excited. IPOs are a huge opportunity for companies — but with the potential for new capital comes a fair share of risks. And that goes for investors, too. If you’re interested in investing in an IPO, remember that the more you can learn about companies’ backgrounds (both financial and management), the better chance you have at scouting out potential winners to add to your portfolio.

Learn more about investing with Ally Invest.