Even novice investors have probably heard the term "IPO" before. IPO stands for "initial public offering" in the stock market. A privately held company that completes an IPO offers, for the first time, shares of itself to the public. Those newly issued shares begin trading on a stock exchange like the New York Stock Exchange or the Nasdaq.

The Wall St. sign in front of the New York Stock Exchange

Image source: Getty Images.

How does an IPO work?

Any privately held company can go public through an IPO. Often companies that complete IPOs are fast-growing companies in the tech industry or another high-growth sector, but they can also be mature companies -- such as Albertsons (NYSE:ACI) and Levi Strauss (NYSE:LEVI) -- that are owned by private equity firms seeking to exit their positions.

When a company is ready to go public, generally after it has a proven track record of growth and other favorable results, it hires an investment bank (or several banks) to underwrite the IPO. Banks underwrite IPOs by committing sums of money to buy the shares being offered before they're listed on any public exchange.

Another role of the underwriter is to perform due diligence on the company to verify its financial information and analyze its business model and prospects. With the help of the underwriter, the company becoming public files a registration statement with the Securities and Exchange Commission (SEC), which includes its prospectus. The purpose of the filing is to provide detailed information on the company's finances, business model, and growth opportunities. 

To secure additional sales of stock before the shares are listed on a public exchange, the company often meets with many institutional investors such as pension funds, foundations, and endowments. After an initial block of shares is sold, the company and its underwriters set an initial public price and a date for the stock to begin trading on a public exchange. 

On the first day of trading on an exchange, the company's stock becomes available to the general public by the underwriter selling its shares. The stock then continues to trade among investors.

A scene from Stitch Fix's IPO

Image source: Stitch Fix.

Why do companies pursue IPOs?

The primary benefit of going public is easier access to capital. The money a company raises via an IPO can be used for expansion, research and development, marketing, and many other purposes.

IPOs also reward equity holders in the formerly private company. Executives, employees, and others who own equity stakes can easily sell their holdings, generally after a lock-up period of six months, once the stock is publicly traded. That lock-up period provides price support for the newly issued shares by preventing insiders from selling their holdings all at once immediately after the IPO.

While private companies are valued based on private rounds of funding, which are burdensome and time-consuming, public companies are valued based on their share prices and numbers of shares outstanding. Stock prices have the potential to appreciate much faster and more easily than private company valuations, assuming the business warrants a valuation increase.

There are also drawbacks to going public since companies are required to adhere to SEC reporting requirements. Publicly traded companies must issue regular disclosure statements, release their financial results, conduct quarterly earnings calls, and generally operate with a high degree of transparency. Public companies have fiduciary responsibilities to their shareholders, whose demands can cause a company's management to lose some control, time, and money -- especially if the company is a target of an activist investor.

Are IPO stocks good investments?

Though IPOs can be good for the issuing companies, they're not always great for individual investors. Investing in IPOs can be profitable, but it is generally much riskier than investing in blue chip stocks or other stocks with substantial histories of strong performance. The prices of newly issued stocks often fluctuate wildly on opening day and the days thereafter as the demand for the new stock is initially unclear.

However, IPO stocks can generate huge returns when the IPOs succeed. Some of today's top public companies completed their IPOs just a few years ago:

  • Facebook (NASDAQ:FB) debuted on the Nasdaq for $38 a share in 2012 and now trades at prices above $300.
  • Tesla (NASDAQ:TSLA) in 2010 priced its IPO at a split-adjusted $3.40 per share, and the stock price in 2020 after a stock split was as high as $900 per share -- representing a value increase of nearly 30,000%.
  • Zoom Video Communications (NASDAQ:ZM) in 2019 priced its IPO at $36, and the stock has since surged past $500 on some trading days, thanks to a pandemic-driven boom in business.

IPO stocks can be great investments but, historically, most underperform the market. The stock market, especially the S&P 500, as a large-cap benchmark index, is generally comprised of successful, profitable companies -- failing and failed companies don't continue to be listed by major indexes.

IPO stocks, which are unproven, may not live up to their seeming potentials. Before investing in IPO stocks, take the time to vet the issuing companies carefully.