What Is an IPO? (Definition and How It Works)

By Indeed Editorial Team

Updated August 31, 2021 | Published April 3, 2020

Updated August 31, 2021

Published April 3, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

When a company holds an initial public offering (IPO), it begins selling its stock to the public. This process can create a lot of organizational changes and it’s important for employees to understand how these changes can affect their company.

In this article, we explain what an IPO is, the process and how going public affects a company and its employees.

What is an IPO?

An initial public offering occurs when a private company initially offers shares of its stock for public sale. This process is known as "going public." IPOs help large companies raise money and investments through the selling of stock on the public market.

Before going public, a company may be owned entirely by the founders or a mix of principals and private shareholders. The ownership structure is completely controlled by the company. After going public, an IPO will select a number of its ownership shares, making them publicly available for purchase. Once the initial public stock offering is complete, the company will no longer have control over who buys its stocks.

Related: What Is a Stockholder?

How does an IPO work?

When a company decides to go public, it works with an investment bank or multiple banks to assist with the process. Multiple banks form what is known as a “syndicate,” and they work together to distribute the risk of buying and selling shares more evenly.

When an investment bank handles an IPO, the process is known as underwriting. Investment banks buy stocks with hopes of selling them at a higher price on the public market during the IPO.

Here are the steps involved when a company goes public. A company must:

1. Meet requirements and regulations

A company will begin to advertise its plans to go public once it can pass rigorous SEC regulations and maintain responsibilities to public shareholders. Usually, companies go public after they have attained a private valuation of around $1 billion.

2. Form an underwriting agreement

The company works with an investment bank to form an underwriting agreement where the underwriter agrees to take on the risk of the offering. Usually, investment banks submit their "bids" outlining an estimate of how much capital the firm will raise during the IPO and how much the bank will generate in profits. The underwriter will buy all of the inventory of stock to be sold in the IPO to sell them on the public market at the set IPO price.

Related: What Is Underwriting? Definition and Types

3. File a registration with the SEC

The bank creates a registration statement and files it with the SEC. This registration statement is detailed and includes information such as financial statements, stock ownership and how the money will be used.

4. Undergo an SEC investigation

The SEC then investigates the firm to ensure that the submitted information is correct and that the firm disclosed all necessary financial data. If the company passes SEC requirements, they then work together to set up a date for the IPO. Once approved, the underwriter creates a prospectus—a document that outlines relevant financial information for potential buyers.

5. Present a prospectus to potential investors

Next, the company has the underwriter present the prospectus to potential investors in a series of events known as a “roadshow.” The goal of the roadshow is to create excitement and momentum for the IPO. During this time, investors put in orders to purchase shares.

6. Establish the price of the IPO

Based on the number of shares bought by initial investors, the underwriter and the company establish the price of the IPO. This is the price that will be presented to the public when the company offers shares on a public exchange.

7. Offer the shares on a public exchange

Once all of the above steps have been completed, the company is ready to go public. Shares of their stock are then put on a public exchange where anyone is able to purchase them.

Related: Public Company vs Private Company: Key Differences

How does an IPO affect a company and its employees?

Many changes take place, both internally and externally, when a company goes public and these changes can affect both companies and their employees. For instance, if your company is going public and you have company stock, you may want to consider your options before the IPO commences.

The following are some of the effects that can occur when a company goes public:

Fundraising

The main advantage of an IPO is an increase in money. IPOs have the potential to raise millions of dollars in proceeds. Funds generated from an IPO are used to benefit the company in a variety of ways. They may choose to use the money to fund research and development, pay off their debts, build new infrastructure, acquire another company, purchase better technology or hire new employees.

Related: Guide To Understanding Venture Capital

Gain credibility and publicity

Financial analysts all over the world report on initial public stock offerings to help their clients make good investing decisions. These events can also make the news, spreading awareness among the general public.

In addition to publicity, an IPO can generate credibility for a company. To go through an IPO process, the SEC thoroughly investigates the company to ensure all the information the firm reports is correct. As a result, individuals tend to trust public companies more than private companies.

Paying with stock

Public companies are allowed to use publicly traded stock to compensate their employees. Public stock is a type of currency that may be purchased and sold at the current market price. Employers that pay their employees with stock or offer stock benefits can attract more talented workers, even if their salaries are not competitive.

Related: The Basics of Incentive Stock Options

Easier acquisitions

After going public, a company may be more likely to acquire and merge with another company. They have more money available, and they can also offer shares as another form of payment. Mergers can lead to a lot of changes, but they usually help companies grow and expand.

Easier to bring in top talent

Public companies can offer stock options and attract talented individuals to their workplaces. These options may be less predictable compensation than a salary, but they have high potential earnings.

What are some disadvantages of going public?

Although there are many benefits to going public, there are also some potential disadvantages to consider. The following are common disadvantages to an IPO:

  • Less control over the company: Once the stock is made available to the public, the company loses some control over final decisions. When a company isn’t public, it owns 100 percent of its stock, and therefore, has 100 percent control. Losing part of this full control can have a significant impact.

  • IPOs generate expenses: Companies take on noticeable expenses in the process of going public, including costs to cover accounting, legal and marketing issues. These additional costs should be taken into consideration when determining if this process is the right step.

  • New disclosure requirements: Public companies have a duty to report or make public certain financial information that private companies do not. This loss of privacy can be an important issue to consider.

  • Less stable stock prices can affect bonuses: When a company goes public, their stock price may fluctuate. This change can affect employees, especially top management if their compensation includes bonuses based on company stock prices.

Related: What Is a Private Company? With Types and Advantages

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