What is an IPO (Initial Public Offering) and How Do I Buy Into One?

First off, what exactly is an IPO? An IPO is an "Initial Public Offering" in which a company will sell shares to the public in order to raise capital.

Let's say that you have a private company, XYZ. XYZ really wants to expand internationally and would like to have easy access to capital, plus their majority shareholders would like to opportunity to spin off some of their ownership in the company into cold hard cash without selling off the entire company. So XYZ will file for an Initial Public Offering, which is the process in which a private company goes public.

Investors buy shares in the company and the company can use that cash to finance its operations. The money that comes from investors does not have to be paid back, however the investors will now have rights as shareholders. In a private company, one person could conceivably own 100% of the company and call all the shots; however, in a publicly traded company, there are shareholders that must be answered to. Also, by being a publicly traded company, XYZ will find it much easier to raise capital in the form of secondary offerings.

When a company wants to go public, it will enter into a contract with one or more underwriters. There are usually one or two lead "underwriters", and numerous other secondary underwriters. These underwriters will try and sell shares to institutions and some retail clients, in return for a hefty commission.

The lead managers in an IPO will determine what they think that the IPO should be priced at. They will base this on many different factors, including current market strength, sector strength, interest in the issue, etc. The IPO will be priced and made available for the general public to buy.

If you want to try and get in on the IPO before it opens for trading on the Nasdaq or NYSE, then you will want to try and get an allotment from your stock broker. The best thing to do is call up your broker to see if 1) they have an allotment of shares that they will be trying to place 2) you can be sold some of this allotment. The more popular a potential IPO, the harder that it will be to get an allotment of shares. All you can do is ask and keep your fingers crossed.

If you don't receive an allotment of shares, then you can always buy the stock after it prices and opens for trading. Keep in mind though that the first trade price when it opens for trading will often be higher than the IPO pricing amount.

Filed under: Stock Market Education | General Knowledge