Even novice investors have probably heard the term "IPO" before. IPO stands for Initial Public Offering. It's the process through which a privately held company offers shares to the public and begins trading on a stock exchange like the New York Stock Exchange or the Nasdaq.

An IPO company therefore is one that has filed to go public, declaring its intentions in a registration statement, or form S-1, with the Securities and Exchange Commission (SEC). The term IPO company can also refer to companies that have recently gone public and are now actively trading on the stock market. 

Black tiles spelling out IPO

Image source: Getty Images.

How IPOs work

Any privately held company can go public through an IPO. Often, companies that IPO are start-ups in the tech industry or another high-growth field funded by venture capitalists, but they can also be mature companies such as Albertsons or Levi Strauss that are held by private equity firms looking to cash out.

When a company is ready to go public, generally after it has a track record of growth and other favorable results, it hires an investment bank (or several banks) to come in and underwrite the IPO. That bank will then put up a sum of money to fund the IPO and agree to buy the shares being offered before they're actually listed on a public exchange. 

The IPO company will file a registration statement, which includes its prospectus, providing detailed information on areas like its finances, results, business model, and growth opportunities. The underwriter must also perform due diligence on the IPO company to verify its financial information and analyze its business model and prospects. 

Once all of the SEC's concerns have been addressed, the company often goes on an IPO roadshow to sell the stock to institutional investors. When the initial block of shares has been sold, or subscribed, the company and its underwriters set an initial price and date for the stock to begin trading. 

On the first day of trading, the stock will become available to the general public as the underwriter sells shares on the stock market. Stocks often fluctuate wildly on opening day, as it's difficult to assess demand for newly public stocks, and it's not uncommon for a stock to double on opening day.

Why go public?

The primary benefit of going public is easier access to capital. The money a company raises can then be used for things such as expansion, research and development, marketing, or whatever else a company needs to grow or reach profitability. In addition to raising money, the IPO also rewards stakeholders in the company, such as employees, investors, founders, and others who own company stock but can't do much with it until that stock starts trading publicly. Once the stock is publicly traded, they can easily sell their holdings if they wish, generally after a lock-up period of six months that prevents insiders from dumping their stock immediately after the IPO.

Additionally, freed from the clunky process of private funding rounds, the stock has the potential to appreciate much faster than it would as a private company, assuming the business warrants it.

There are drawbacks to going public, however, as companies are required to adhere to SEC reporting guidelines, putting out regular disclosure statements and sharing their financial results, or opening up their books for all to see. Furthermore, a public company will also need to start answering to its shareholders, including in quarterly earnings calls. Those demands mean that management loses some control, as well as time and money, in exchange for that additional funding. Still, it's often a reasonable trade-off to make.

Are IPO stocks good investments?

Though IPOs can be good for the companies behind them, they're not always great for individual investors -- especially the inexperienced kind. Though investing in IPOs can be profitable, it's generally a much riskier prospect than investing in established blue chip stocks with a history of solid performance. However, IPO stocks can reap huge returns when they're successful. Some of today's top stocks were IPOs just a few years ago. Facebook (NASDAQ:FB), for example, debuted for $38 a share in 2012, and is now above $250. Tesla (NASDAQ:TSLA) priced its IPO at a split-adjusted $3.40, and the stock ran up as high as $500 after its recent stock split, a return of nearly 150 times the original investment. Looking at more recent history, Zoom Video Communications (NASDAQ:ZM) priced its initial offering at $36 last year, and the stock surged past $450 after its recent earnings report.

Overall, it's important to remember that IPO stocks have historically underperformed the market. That's because the stock market, especially the large-cap benchmark S&P 500 index, is generally made up of successful, profitable companies, as failing companies don't stay in the index. IPO stocks, on the other hand, tend to be high-risk plays, and many of them do not live up to their potential.

Those inclined to invest in IPO stocks should therefore take the time to vet the issuing companies carefully before moving forward.