What Is an IPO? How an Initial Public Offering Works

Search Fintrev

Search our guides, reviews and glossary.

An IPO (initial public offering) is the first sale of a private company’s shares to the general public, after which those shares trade on a stock exchange. In the IPO the company sells newly issued stock to outside investors, usually through investment banks that underwrite the deal. From that point it operates as a public company, with the disclosure obligations, shareholder base and market price that come with that status. The full form of IPO is simply “initial public offering”: initial because it is the first time, public because anyone with brokerage access can eventually buy, and offering because shares are being offered for sale.

What Is an IPO?

Before an IPO, a company’s shares are held by a limited group: founders, employees with equity grants, friends and family, angel investors, venture capital funds and sometimes private equity firms. Those shares cannot easily be sold, because there is no public market for them. A buyer has to be found privately, and transfers are often restricted by shareholder agreements.

An IPO changes that in two ways at once. First, the company raises money by selling a portion of its ownership to new investors. Second, the company lists its shares on an exchange, so that from the first trading day anyone can buy or sell them through a broker. The offering itself happens in the primary market, where the issuer sells securities and receives the proceeds. Everything after the first trade happens in the secondary market, where investors trade with each other and the company receives nothing from those trades.

In business terms, an IPO is both a financing event and a change of status. It is a financing event because the company exchanges ownership for cash. It is a change of status because the company takes on permanent obligations: audited financial statements, quarterly and annual reports, disclosure of material events, an independent board structure and exposure to shareholder votes and public scrutiny.

How an IPO Works

From private shareholders to public shareholders

When a company goes public, its existing private shares do not disappear. They convert into the same class of common stock that the public buys, or into a separate class if the company adopts a dual-class structure that gives insiders extra voting rights. Once trading begins, those shares are valued at the market price, so a founder holding a fixed number of shares sees a public price attached to that stake for the first time.

Primary shares and secondary shares

An IPO can contain two kinds of shares, and the difference determines where the money goes:

• Primary shares are newly issued by the company. The cash, minus underwriting fees and expenses, lands on the company’s balance sheet and increases shareholders’ equity. Issuing them also increases the total share count, which dilutes existing holders’ percentage ownership.
• Secondary shares are existing shares sold by current holders such as founders, venture funds or executives. The cash goes to those sellers. The company’s share count does not change, and the company receives none of the proceeds.

Many IPOs mix both. The prospectus states how many shares of each type are being sold and who the selling shareholders are, which tells an investor how much of the deal is fresh capital and how much is an exit for insiders.

The role of underwriters

Underwriters are investment banks hired to manage the offering, typically through the equity capital markets group working with the investment banking team that covers the company. The bankers advise the company; the capital markets side reads investor demand, structures the deal and runs pricing and distribution. Large IPOs usually have a syndicate of lead managers (bookrunners) plus co-managers who help sell the shares.

Two common underwriting arrangements are:

• Firm commitment: the underwriters agree to buy the entire offering from the company at a set price and resell it to investors. If demand falls short, the banks are left holding the unsold shares. This is the standard structure for large U.S. IPOs.
• Best efforts: the underwriters agree only to try to sell the shares and do not guarantee the amount raised. This structure shows up more in smaller offerings.

The banks are paid through the underwriting spread (also called the gross spread): the difference between the price investors pay and the price the company receives per share. Legal fees, accounting and audit fees, exchange listing fees, printing and roadshow costs come on top of the spread.

The IPO Process Step by Step

An IPO takes months of preparation before the shares trade. The sequence below reflects a traditional U.S. underwritten IPO; individual deals vary in timing and detail.

1. Readiness review. The company checks whether its finances, controls and governance can withstand public-company reporting, often upgrading accounting systems, hiring a chief financial officer with public-company experience and completing audits of several years of financial statements.
2. Selecting underwriters. Banks pitch their proposed valuation, offering size and structure, type of security, exchange and timeline. The company picks its lead bank or banks, and the terms are later formalized in an underwriting agreement.
3. Forming the deal team. The working group includes the underwriters, company counsel, underwriters’ counsel, independent auditors and advisers experienced with SEC filings.
4. Due diligence and drafting. The team investigates the business and drafts the registration statement, for most U.S. domestic issuers Form S-1. It has two parts: the prospectus distributed to investors, and additional information filed with the SEC but not included in the prospectus.
5. SEC review. SEC staff send comment letters, and the company responds and files amendments, often over several rounds.
6. Setting the price range. An amended registration statement adds a proposed price range and share count. This preliminary prospectus is called the “red herring” after the red legend on its cover stating that the information is incomplete and may change.
7. The roadshow. Management and the underwriters present the company to institutional investors in person and by video. Collecting their indications of how many shares they would buy and at what price is called book building.
8. Governance setup. The company finalizes its board, including the independent directors and audit committee members required by exchange rules, and sets up quarterly reporting processes.
9. Effectiveness and pricing. Once the SEC declares the registration statement effective, the company and underwriters set the final offer price, usually the evening before trading. It can land inside, above or below the range, and the share count can also change.
10. Allocation and first trade. Underwriters allocate shares at the offer price. The next morning the stock opens at a price set by buy and sell orders in the market, not by the underwriters, so it can differ substantially from the offer price.
11. Closing and post-IPO period. A few days after pricing, the company delivers the shares and receives the net proceeds. The underwriters’ over-allotment option, insider lock-ups and the research quiet period then take effect.

The legal framework in the U.S.

Two federal statutes frame the process. The Securities Act of 1933 requires a public offering to be registered with the SEC unless an exemption applies and creates liability for material misstatements or omissions in the registration statement, which is why underwriters and lawyers spend so much time on due diligence. The Securities Exchange Act of 1934 governs life after the IPO: reporting on Form 10-K (annual), Form 10-Q (quarterly) and Form 8-K (material events), proxy rules and insider trading reporting.

Later laws adjusted the process. The Sarbanes-Oxley Act of 2002 added requirements on internal controls over financial reporting and executive certification of financial statements, which raised the cost of being public. The JOBS Act of 2012 created the “emerging growth company” category, which lets qualifying smaller issuers submit draft registration statements confidentially for SEC review and phase in some disclosure obligations.

Also from the pre-IPO period comes the quiet period: restrictions on what the company can say publicly while it is in registration, so that promotional statements outside the prospectus do not condition the market. Rules have loosened over time, but companies still limit publicity around an offering.

Listing on an exchange such as the New York Stock Exchange or Nasdaq requires meeting that exchange’s own standards, which cover items such as minimum share price, number of shareholders, market value of publicly held shares and corporate governance. SEC registration and exchange listing are separate approvals.

How an IPO Is Priced

The offer price comes out of two inputs: a valuation of the company and the demand the underwriters discover during book building.

Valuation

Underwriters and investors estimate what the business is worth using standard corporate finance methods:

• Discounted cash flow. A discounted cash flow (DCF) model discounts projected free cash flows back to a net present value, typically at the company’s weighted average cost of capital (WACC).
• Comparable companies. Analysts apply multiples of similar public companies, such as price to earnings, EV/EBITDA or EV to revenue. This matters most for younger, unprofitable companies, where a DCF rests on long-range assumptions.
• Enterprise value and equity value. Enterprise value covers the whole business, including debt. Subtracting net debt gives equity value, and dividing by the post-IPO share count gives a value per share.

Demand and the IPO discount

Valuation gives a starting range; book building tests it. If the order book is heavily oversubscribed (investors want many more shares than are available), the underwriters may raise the range, increase the share count or both. If demand is weak, they may cut the price, shrink the deal or postpone it.

Underwriters commonly set the final price somewhat below what they believe the market will pay. The discount gives buyers at the offer price a reason to participate and makes a first-day price rise more likely. When the stock jumps on its first day, the gap between the offer price and the trading price is often described as “money left on the table”: value that went to the investors who were allocated shares rather than to the company or its selling shareholders.

Over-allotment (greenshoe) option

Most underwritten IPOs include an over-allotment option, known as a greenshoe after the company that first used it. It lets underwriters sell up to 15% more shares than the base offering, creating a short position at the outset. If the stock trades below the offer price, they buy shares in the market to cover the short, which supports the price. If it trades up, they exercise the option and buy the extra shares from the company at the offer price. Either way, the banks can stabilize early trading.

Example of an IPO

The following is a hypothetical example with made-up numbers, used only to show how the pieces fit together.

Before the IPO. Northfield Software, a private company, has 80 million shares outstanding. The founder owns 32 million (40%), venture funds own 36 million (45%) and employees own 12 million (15%).

The offering. Northfield prices its IPO at $25 per share. The offering includes:

• 20 million primary shares sold by the company
• 5 million secondary shares sold by the venture funds

That is a base offering of 25 million shares, worth $625 million at the offer price.

Where the money goes. Assume an underwriting spread of 6% (an assumption for this example, not a market standard) and $5 million of other offering expenses paid by the company.

• Company gross proceeds: 20 million × $25 = $500 million
• Underwriting spread on primary shares: $500 million × 6% = $30 million
• Other expenses: $5 million
• Company net proceeds: $465 million
• Venture funds gross proceeds: 5 million × $25 = $125 million, less their share of the spread (6% = $7.5 million), leaving $117.5 million

Share count and valuation. After the IPO there are 80 million + 20 million = 100 million shares outstanding. The secondary sale does not change the count. At $25, Northfield’s market capitalization is 100 million × $25 = $2.5 billion.

Dilution. The founder still holds 32 million shares, but now owns 32 million ÷ 100 million = 32%, down from 40%. The stake is worth $800 million at the offer price.

Greenshoe. The option covers 15% of the 25 million base shares, or up to 3.75 million more. If it is exercised in full with new company shares, the count rises to 103.75 million and the company receives additional proceeds.

First day. Suppose the stock opens at $30 and closes at $32. Investors allocated shares at $25 gain $7 per share on paper. On the 25 million base shares, that is $175 million of value above the offer price, the “money left on the table” in this scenario. None of the first-day gain reaches the company, because the company sold its shares at $25.

Why Companies Go Public

The core purpose of an IPO is to raise equity capital. Companies use the proceeds for purposes such as funding expansion, entering new markets, research and development, acquisitions or paying down debt. The prospectus includes a “use of proceeds” section stating the intended uses.

Other motivations include:

• Liquidity for existing holders. Founders, employees and investors can sell shares in the IPO or after lock-ups expire. For venture and private equity funds, an IPO is one of the main exit routes.
• A public currency. Listed stock can pay for acquisitions and compensate employees through stock plans, and liquid shares attract recruits more than illiquid private equity.
• Future financing. A public company can raise more later through follow-on offerings, and its disclosure record can help it borrow on better terms.
• Visibility and credibility. Listing raises the company’s profile with customers, suppliers and lenders.
• Valuation. If public investors will pay more than private buyers, the company and its holders can realize a higher price, and the market then gives a continuous, observable valuation.

Disadvantages of an IPO

• Cost. Underwriting spreads and legal, accounting and marketing costs are substantial, and many costs are ongoing: audits, internal controls, investor relations, directors’ insurance and compliance staff.
• Disclosure. The company must publish financial, accounting, tax and business information, including details competitors can use.
• Management time. Quarterly reporting, earnings calls and investor meetings absorb executive attention.
• Short-term pressure. Share price swings can distract management, especially when pay is tied to stock performance rather than underlying results.
• Loss of control and agency problems. Founders are diluted, public shareholders vote on key matters, and owners and managers grow further apart. Dual-class structures reduce this for founders but shift the governance concern to public investors.
• Governance constraints. Board oversight and formal controls can make it harder to move quickly.
• Market timing risk. If markets fall during the process, the deal may be priced lower, cut in size or pulled.

Alternatives to a Traditional IPO

Going public through an underwritten IPO is one route among several, and staying private is always an option.

Direct listing

In a direct listing, the company lists its existing shares on an exchange without an underwritten offering or book building, and the opening price is set by orders on the exchange. Rules now also allow a primary direct listing in which the company raises money. The company avoids the underwriting spread and the IPO discount, and holders can usually sell from day one without a traditional lock-up, but no bank guarantees demand or stabilizes the price. Direct listings tend to suit companies with well-known brands and existing investor interest.

Dutch auction

In a Dutch auction IPO, investors bid how many shares they want and the price they would pay instead of the price being set through book building. The price is set at the level at which all offered shares can be sold, and bidders at or above it receive shares at that same clearing price. Google used a modified Dutch auction for its 2004 IPO. Auctions aim to make allocation less dependent on underwriters’ relationships but remain uncommon in the U.S.

SPAC merger

A special purpose acquisition company (SPAC) is a shell company that holds its own IPO to raise cash, then uses that money to merge with a private company. The private company becomes public through the merger rather than through its own IPO. SPAC deals can move faster and allow the parties to negotiate a valuation directly, but they bring their own costs, including the sponsor’s equity stake and the possibility that SPAC shareholders redeem their shares instead of staying in the deal.

Other routes

Companies can also stay private and keep raising money from venture capital, private equity or strategic investors, take on debt, use grants, crowdfunding or a direct public offering for smaller raises, or sell the whole business. Each avoids public-company obligations, but none creates a liquid market for the company’s shares.

Investing in an IPO

How individuals get access

Shares at the offer price are allocated by the underwriters, and the bulk usually goes to institutional investors such as mutual funds, pension funds, hedge funds and insurers, largely the accounts that helped gauge demand. Individuals can sometimes get IPO shares through a brokerage that received part of the allocation, but eligibility rules vary, some brokers require a minimum account size or activity, and popular deals are often oversubscribed.

Most individual investors buy once trading opens, paying the market price, which in a deal that jumps on its first trade can be well above what institutions paid the night before. Another route is a mutual fund or exchange-traded fund that specializes in recent IPOs, which spreads the risk across many new issues.

Reading the prospectus

The prospectus is the primary source of information on an IPO and becomes public when the registration statement is filed. Sections worth reading closely include:

• Risk factors: the company’s own list of what could go wrong.
• Use of proceeds: planned uses, including whether part repays debt or goes to insiders.
• Management’s discussion and analysis (MD&A): management’s explanation of results, trends and key operating metrics.
• Financial statements: audited results, from which return on equity, margins and cash burn can be calculated.
• Dilution: how far the book value per share of new investors’ stock falls below the price they pay.
• Principal and selling shareholders: who owns what before and after the deal, and who is selling.
• Capital structure and governance: share classes, voting rights and board composition.
• Underwriting: the banks, the spread, the over-allotment option and lock-up terms.

Why IPOs are volatile

A newly public company has no trading history, little analyst coverage from banks outside the syndicate and often a short record of profitability. Because insiders are locked up, the free float (shares available to trade) is often small, and small float plus intense attention can produce large swings in either direction. Some heavily promoted IPOs stumble right away; others gain quickly and then fade, depending on the company’s competitive position, whether the shares were priced too high or too low, and market conditions.

Lock-up periods

A lock-up agreement is a contract between the underwriters and company insiders (executives, employees, pre-IPO investors) that bars them from selling shares for a set period after the IPO. Lengths are set deal by deal in the underwriting terms, and they can range from a few months to two years. The prospectus states the exact terms, including any early-release provisions.

When the lock-up expires, a large block of shares becomes eligible for sale, and insider selling can push the price down. Expiration dates are disclosed in advance.

Separate from the contractual lock-up, insiders’ pre-IPO shares are generally “restricted securities” under SEC rules, and resales are governed by Rule 144, which sets holding periods and conditions before such shares can be sold publicly. Affiliates of the company face additional limits on volume and manner of sale.

Research quiet period

After the IPO, analysts at the underwriting banks are subject to a waiting period before they publish research on the company. When that period ends, several syndicate banks often initiate coverage around the same time, which can move the stock.

Waiting periods and flipping

Some offering terms set aside a portion of shares for purchase after a specific period rather than at the IPO. Flipping is reselling IPO shares within the first few days to lock in a first-day gain, which investors with discounted allocations have an obvious incentive to do. Underwriters and brokers may discourage it, for example by limiting future allocations to accounts that flip.

Carve-outs and spin-offs

An established company can take part of its business public through an equity carve-out: the subsidiary holds its own IPO and the parent sells a minority stake while usually keeping control, on the reasoning that a division with different growth prospects may be valued more highly on its own. Investors can draw on the parent’s financial history as well as the subsidiary’s filings, so more information is often available than for a startup IPO.

A spin-off is different: the parent distributes shares of the subsidiary to its existing shareholders instead of selling them, so no IPO capital is raised. A tracking stock is different again: it is a class of the parent’s own stock designed to follow a division’s performance, and the division does not become a separate company.

History of IPOs

The Dutch East India Company is widely credited with the first modern public offering. In 1602 it sold shares to the general public in the Dutch Republic, and those shares later traded in Amsterdam, an early example of both a public share sale and a secondary market for shares.

Since then, IPO activity has moved in waves, rising when stock markets are strong and drying up when they fall, with individual sectors following their own cycles. The late-1990s dot-com boom brought a surge of technology IPOs, many from startups without meaningful revenue, and the crash that followed wiped out much of that value. The 2008 financial crisis pushed new listings down sharply for a period.

IPO vs. Related Terms

Several terms get mixed up with an IPO:

• IPO vs. going public. An IPO is one way to go public. Direct listings and SPAC mergers also produce a public company without a traditional IPO.
• IPO vs. listing. The IPO is the sale of shares; the listing is admission to trade on a specific exchange. A direct listing is a listing without a traditional offering.
• IPO vs. follow-on offering. An IPO is the company’s first public share sale. Any later public sale of shares by a listed company is a follow-on (or seasoned) offering.
• Secondary offering vs. secondary market. A secondary offering is a sale of existing shares by current holders, in an IPO or later. The secondary market is ordinary trading between investors after the shares list.
• Offer price vs. opening price. The offer price is set by the company and underwriters and paid by investors who receive allocations. The opening price is the first trade on the exchange, set by market orders.
• Market capitalization vs. amount raised. In the hypothetical example, Northfield was valued at $2.5 billion at the offer price but raised $500 million gross. The valuation covers all shares outstanding; the raise covers only the shares the company sold.
• Corporation vs. other legal forms. Going public generally means issuing stock as a corporation, so entities such as an LLC usually convert to a corporation before an IPO.

FAQs

The Bottom Line

An IPO matters to companies seeking capital and liquidity for insiders, and to investors weighing new listings. Companies gain funding and a public currency but take on lasting costs, disclosure and scrutiny. Most individuals buy after trading opens at a market price that can sit far above the offer price, so reading the prospectus and watching lock-up expirations helps them judge what they are paying for.