They make for some of the most enticing headlines in financial media. They often get choice real estate on the pages of The Wall Street Journal, and the juicier ones have excited pundits barking about them on CNBC:
"Wonky Widgets Stock Going Through the Roof in IPO"
"NothingButLosses.com IPO Priced at $19 Per Share"
"Largest Artificial Toe Maker Global Domination Ltd. Files for IPO"
Why the prominence, and why the frothing excitement? What exactly is an IPO, anyway?
"IPO" stands for "initial public offering." That three-word combination nicely boils down the root concept -- a company offers shares of its stock to the general investing community for the first time.
Essentially, the company offers a part of itself to investors like you or me -- hence the term "going public" -- via one of the stock exchanges. These days in America, this is pretty much a two-horse race between Intercontinental Exchange's (NYSE:ICE) New York Stock Exchange, and Nasdaq OMX Group's (NASDAQ:NDAQ) Nasdaq.
The company unloads a certain number of shares representing a portion of the overall ownership stake through the chosen market. The company uses its net sales from that issue to fund investments, retire debt, enrich founding shareholders, and/or employ any number of other uses a big pile of money can be put to.
Privately held companies have one big disadvantage, in that their options to raise significant capital are very limited. Most businesses don't generate enough free cash flow to rapidly fund ambitious expansion plans.
Its only other real alternatives are to draw in more investors, or take out some form of debt financing such as bank loans. But sugar-daddy investors are rare, first of all, and second, they typically demand a big chunk of the business in return for their investment.
A capital-hungry enterprise can borrow money -- assuming it can find a lender willing to shell out the full amount needed -- but of course, debt has to be repaid, with interest and within a certain time frame.
In contrast, selling shares raises capital that doesn't have to be paid back, plus it can easily be done while retaining a controlling stake. It's also fast. When engineered successfully and well, an IPO can raise the necessary funds in a relative hurry -- one typically takes around three to four months to organize and launch.
So we should all incorporate, rush to the trading floor of the NYSE to announce we're a public company, and then watch the money barrel on in!
Not so fast. Every exchange has a set of criteria for companies coming to market, and the bar's set pretty high.
Nasdaq mandates that its stocks have a minimum of 1.25 million shares upon listing, a minimum per-share price (usually $4), and three market makers -- brokers who guarantee they'll always buy or sell the stock -- behind it. And that's just for a start; there are a host of other guidelines.
That's why stock market offerings, for the most part, are comparatively large, even for companies that are hardly gigantic. For example, gym chain Planet Fitness issued 13.5 million shares in its IPO floated earlier this summer.
No matter how diligent and dedicated an enterprise, the chances are it doesn't have the wherewithal to sell millions and millions of shares. That's where underwriters come in.
These are financial professionals -- more often than not, the investment banking arms of big financials such as JPMorgan Chase or Citigroup -- that basically act as the salespeople for the IPO.
They divvy up those millions of shares (either by taking them on their own books at an agreed price, or simply brokering them), and attempt to sell them in the IPO. The underwriters take a set of fees for their work and are usually allotted shares in the issuing company.
So everybody wins, yes? The business raises money, the founders become obscenely rich, and the public gets a cool new company in which to own stock. What could possibly be the downside?
Well, there are many. A publicly traded company is obligated to reveal its finances, in great detail, to the public. And that's just one set of a host of rules the stock's exchange mandates to maintain the listing. There are accounting rules, trading rules, corporate governance rules, and on and on. The list is very long, and it's not easy or cheap to comply with.
So an IPO is definitely not for every business. An enterprise that doesn't need gobs of capital for expansion (such as your local mom-and-pop sandwich store) probably doesn't need to go public. Likewise, a business that has managed to grow large on its own, with a relatively small group of shareholders at the helm, also might not find it necessary.
IPOs had been coming at us thick and fast thanks to the sustained bull market of recent times -- for obvious reasons, it's best to sell new shares in an atmosphere of optimism and hope (investors are being asked to buy shares of a business that is unproven on the market, after all). That's why, with the recent volatility, we're now witnessing an abrupt halt to IPO activity.
But it'll come back sooner or later. After all, there's a lot of investor money out there, and more than enough ambitious, capital-hungry businesses eager to go after it.
Eric Volkman has no position in any stocks mentioned. The Motley Fool recommends Intercontinental Exchange and Nasdaq OMX Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.