If you follow business and financial news, chances are, you've ready about a company "going public" before. But what does it mean to go public, and how does it affect a business?

In this video, The Motley Fool's own Dylan Lewis breaks down exactly what an initial public offering (IPO) is, and why you should care about them. 

A full transcript follows the video.


Narrator: In this FAQ video, we're going to talk about IPOs and why a company would want to go public.

An IPO is an initial public offering – or the first time a company makes shares available to the public for purchase. 

Before we get into the X's and O's of IPOs, it's helpful to understand how businesses get money for funding:

If you're running a business, you have a couple different ways to raise money:

  • You can take on debt — where you borrow an amount of money and pay it back over time in installments... plus interest. This can take the form of a loan from a bank, or debt the company issues itself.
  • OR you can issue equity — when you do this, you're making ownership of your company available, and in exchange for that ownership, the new shareholders pay some amount of money. You don't have to make any interest payments, but you have to share ownership of your company.

Now companies can issue equity privately, and often this is how early stage companies raise funds, meaning that they are making a deal with investment firms or angel investors to exchange some percentage ownership of their company for some large chunk of money. If you've ever watched Shark Tank, you've seen this at play.

Raising money privately is helpful early on – the company doesn't have to publicly disclose as much information and management doesn't have to worry about market noise. But that shield comes at a cost – it's a lot harder for people who hold shares in private companies to turn their shares into cash.

Because of this, eventually many large businesses will reach a point where they want to "go public" and list shares on an exchange where they can easily be traded.

If that's the case, the company will go through an IPO. 

That means the company will work with an investment bank like Goldman Sachs or JP Morgan. These banks will "underwrite" the IPO, meaning that they will determine a valuation for the company, buy the shares from the company at a set price, then distribute them and help the company file with the Securities and Exchange Commission and get listed on exchange like the New York Stock. 

This whole process often takes several months and when shares finally list, the company will throw a big party, sometimes the executives will even ring the opening bell at the stock exchange the company lists on.

IPOs get a lot of buzz, but often its better to stay on the sidelines as an investor.

Because IPOs are the public's first chance to buy into a company, there is often a lot of pent up demand to buy shares when they first become available. This leads to a lot of funky price movements, because the value is being dictated by the short-term spike in demand, not business results which actually drive stock prices over time.

Also, an important thing to remember – most of the time the company is choosing when it is going public... so they're going to do it at a time when it is advantageous for them to do so.

  • Think about it, if you were going to sell a portion of a business you ran, you'd want to get the most you could for it, right? So you'd probably do it when business results looked really strong.

The same logic applies to IPOs – at their core, IPOs have a couple major players, and their incentives are all aligned:

  • The business – The money from the business selling shares to the investment banks goes directly to the company, giving them cash to work with, so the company wants to raise as much as it can. You'll often hear IPOs called a "capital raising" event.
  • The investment bank – The investment bank has bought shares from the company and is usually selling them to big clients and high net worth individuals. The investment bank wants to make sure it can sell what it bought, and wants its valuable clients to be able to make money on the shares so that they stay happy. So they want the shares to price high and gain value short-term.
  • Early investors – Most private companies have early investors, venture capitalists, big investment firms, and angel investors. These folks have had their money tied up in the private company for a while and often are ready to sell their stake and make a return on their investment. For them, IPOs are an "exit opportunity"
  • Founders and employees of the company -- Founders and early employees of companies that go public often have a lot of their personal wealth tied up into the business through shares they've accumulated. For these folks, IPOs are a "liquidity event" , meaning they give people the chance to convert stock into cash.

All of these people generally want to maximize the value of the business around the time it IPOs – it means the company raises as much money as it can, and it means people "exiting" their investments are getting top dollar for the shares they're selling. There's nothing wrong with that, but those incentives, on top of overwhelming market demand, can often cause shares to spike, then fall after an IPO.

For that reason, its often best for the average investor to wait a bit before buying into a company that has recently gone public. Doing that gives time for the market to settle down and it gives investors the benefit of seeing a few quarters of business results and how the company's management handles the scrutiny of the public markets.

Ultimately, those are the factors that decide whether a stock is worth owning.

Thanks for watching guys, if you enjoyed this video we've got plenty more like it coming, hit subscribe down on the bottom right and give us a thumbs up. And if you have any questions on things I hit in the video, drop them in the comments section below, we love getting ideas for future videos!