The ABCs of IPOs
A Motley Fool Special Report

By Yi-Hsin Chang, TMF Puck

Special Feature

Part 1
What IPOs Are and Why They Happen

Part 2
How to Get In on an IPO

Part 3
New Ways Companies Are Issuing Shares

Talk About IPOs and This Special on the IPO message board

The term "IPO" is bandied about as frequently as "the Dow," "DRIPs" and "P/E," but it's probably the most misunderstood of them all. I imagine some investors don't even know what the letters stand for. I once saw a cute T-shirt in a shop window showing the letters "IPO" followed by an arrow pointing downward. It was a shirt meant to be worn by a pregnant woman about to have her first child -- her "initial public offering" as it were.

If you're thoroughly confused about IPOs, don't worry. It will all become clear here, as we spell out the ABCs of IPOs. We will explain initial public offerings and why they may not be all they're cracked up to be.

What is an IPO?

An initial public offering (IPO) is basically a company's first sale of stock to the public. Typically, an IPO involves the stock from a young and oftentimes little-known, if not obscure, company. But occasionally, well-known and well-established firms do "go public." For example, last November, Rupert Murdoch's Australia-based media company News Corp. (NYSE: NWS) sold 18.6% of Fox Entertainment (NYSE: FOX) -- which owns, among other things, the FOX broadcast network, one of the top movie studios, and local TV stations -- to the public, raising $2.81 billion. Another well-known company planning to go public soon is none other than investment banking firm Goldman Sachs.

Now don't confuse a follow-on offering or a secondary offering with an IPO. A follow-on offering occurs when a company that's already public -- meaning it has already done an IPO -- sells more shares to the public. Think of the pregnant woman analogy. A woman can't have a firstborn more than once, but she can give birth multiple times. A secondary offering, on the other hand, involves selling shares belonging to existing shareholders.

Why do companies go public?

To raise money. Recently, it seems that just about every company with a "dot-com" in its name has been "cashing in" on investors' seemingly insatiable appetite for Internet company IPOs. The most extreme case of Internet mania of late involved online community (Nasdaq: TGLO), which shot up nearly 11 times its IPO price of $9 in its first day of trading, finishing the day up $54 1/2, or 600%, to $63 1/2. Not bad for a business run by two 24-year-olds who started out with $15,000 raised from family and friends. Immediately following the IPO, the stock traded mostly in the $30 to $45 range.

If you're a cynic, you might say that a company opts to go public because it expects to reap little profit -- making it cheaper to have shareholders than to owe fixed interest payments -- or that the company simply can't get funding from traditional lenders, meaning that it's in a high-risk business. If either is the case, as is true for many IPOs, you should avoid jumping on the IPO bandwagon at all costs.

Of course, there are legitimate reasons for going public, such as increasing the company's financial base, liquidity, prestige, and ability to attract management and make acquisitions. Or, it could be that an established company is spinning off subsidiaries to "unlock hidden value," as in the case of Fox Entertainment -- News Corp. has long complained that its shares have been undervalued.

Why don't companies go public?

Some companies choose to stay private so they don't have to share the profits, be accountable to shareholders, relinquish control over how the company is run, or disclose "secret" company information.

British "adventure capitalist" Richard Branson of Virgin Group makes a compelling argument against going public. In his recent autobiography, Losing My Virginity, Branson says that soon after the company's IPO he felt constrained by the "onerous obligations" of being a public company, especially the duty of appointing and working with outside directors. "Our business was not one that could be boxed into a rigid timetable of meetings. We had to make decisions quickly, off-the-cuff: if we had to wait four weeks for the next board meeting before authorizing Simon to sign UB40, then we would probably lose them altogether."

Branson also didn't want to follow the British tradition of paying a large dividend. He preferred the practice accepted in the U.S. and Japan of reinvesting profits to increase shareholder value. Branson views the one year Virgin was public as the company's least creative year because he and other top executives spent at least half their time talking to fund managers, financial advisers, and PR firms, explaining their business. The company's management ended up conducting a management buyout to make Virgin private again.

Next -- How to Get In on an IPO