What’s an IPO?
Initial public offering (IPO) is a term that comes up a lot in investing. In a nutshell, it’s a process that a company goes through to become ‘listed” on an exchange. Once listed, pretty much anyone can invest in it by buying shares—including you!
Let’s look at why a company might offer an IPO, how they do it, and what to do before you invest in one!
Before the IPO
Before a company lists on an exchange, like the Australian Securities Exchange (ASX), we’d call it a private company. Fun fact: there’s a subset of these companies called unicorns, which are private companies worth US$1b or more.
To become a listed company a company must go through a rigorous listing process.
Why companies IPO
At its core, an IPO is about raising money. But there are different reasons that companies may want to raise money. For example:
they may need the funds to pursue opportunities for future growth
existing shareholders (including employees, directors, and founders) may want to sell some—or all—of their shares in the company and turn their investment into cash
the company may need to pay down debt.
Of course, it could be a combination of reasons, or a different reason entirely.
The bottom line is that raising money is a starting point. There are many things that a company can do with the money raised, so it pays to have an understanding of what the company’s future plans are.
How companies list
Listing is a complex, time-consuming, and expensive process. This is because there are lots of rules and regulations around listing. After all, when companies give regular people like you the ability to invest in them every day, you need to be confident that the company meets basic criteria such as sharing all the relevant information you need.
First, the legal prep work
An investment bank often helps a company go through the steps required to list. They project managing things like getting lawyers on-board to prep legal documents, finding investors to buy the initial shares, and lots of other things!
All of this prep work—and the rules and legal requirements—aim to protect shareholders and investors.
Meeting the listing rules
An exchange sets the rules a private company needs to follow so it can list and remain listed.
Most exchanges have similar rules, but there can be differences around things like a company’s minimum value and how trading happens.
In Australia, the ASX provides rules and guidelines for companies that want to publicly list. You can have a look at these rules on the ASX website—warning, there are a lot of them!
Deciding on a share price
A company needs to do lots of research and analysis to figure out how much to sell their shares for.
If it sells its shares for too little, it might not raise as much money as it could have. But if it sets the price too high, there might not be enough people who want to buy the shares!
Once the company has decided on a price—and has done all the necessary prep work—it can set a date for the IPO.
The thing to remember about this process is that the company has a lot of information and expertise when they’re setting the share price. They also have a lot to lose if they set it too low, but not as much to lose if they set it too high.
When shares start trading
Once a company lists, its shares can be bought or sold just like any other listed company on the exchange.
If you purchased shares in the IPO, after the company lists and trading starts, you might benefit from a rise in the share price—but this doesn’t always happen! Prices might go down depending on what the demand for the shares is like. If it’s higher than the price the company set, then prices will go up. If it’s lower, they’ll go down.
Demand for shares could be high—or low
An IPO can be ‘oversubscribed’. This means people want to buy more shares than a company is offering. If this happens, the offer might be ‘scaled’, which means investors may end up getting fewer shares than the amount they’d like to buy.
IPOs can be ‘undersubscribed’ too, which means the company has offered more shares than people want to buy. If an IPO is undersubscribed, it might be worth looking at why the demand is low.
The share price could drop
IPOs can be exciting, but it can be risky for a company—and new shareholders too.
Facebook (FB) went public in May 2012 at a price of US$38 per share. By September 2012, it had dropped below US$18 per share. Ouch. It took over a year to reach the IPO price again.
Investors need to be kept in the loop
A listed company needs to stick to the listing rules and legal requirements. Typical exchange rules require something that is called “continuous disclosure”. Continuous disclosure requires a listed company to keep the market up to date with material news about what's happening with the company so investors or potential investors can make an informed choice about what to do. Each exchange and its rules are different and there are limitations to what a company has to disclose and when.
Listed companies need to be regularly audited by a professional auditor, have a board, and release reports about how the company is performing.
All of this stuff is expensive, so listed companies tend to be larger, or have plans to grow in the future.
Taking part in an IPO
An IPO gives you the opportunity to invest in a company’s shares while they’re on the ‘primary market’. The primary market is where shares are issued for the first time. The shares go into the ‘secondary market’ when they’re listed and traded on a stock exchange.
It’s all right to feel a little out of your depth. But there are a few things you can do to help manage your feelings of uncertainty.
Do your due diligence
Due diligence is just another way of saying ‘doing your homework’.
A company will release a document called a product disclosure statement (PDS) before it lists—make sure you read it! It tells you key info about the company, like its financial position and performance. You can also find out why the company is making the offer, how it expects your investment to make a return and some known risks to the business that might affect your investment.
A PDS can be a chunky document to get through, so think about what you want to learn before you dive in. Here’s some stuff you might like to think about (it's not an exhaustive list and as always you’ll need to think about your own situation and whether the investment is right for you):
Look at the company’s financial track record and forecasts. Has it been consistently gaining customers, revenue, and profit over the last few years, and do you think that the predicted growth is realistic?
Compare this to what the company thinks it's worth. In the PDS you should be able to find its implied ‘market capitalisation’ value. This valuation should represent what the company’s worth—but unfortunately, sometimes it doesn't. Are there similar companies that have wildly different valuations? You’ll need to look outside of the PDS for this information.
Understand what the company will use its raised capital for. Common things a company will allocate money for include, paying off debt, raising money to fund growth opportunities, and allowing existing shareholders to sell their shares. Do you think that the way it's allocating money supports what it has planned for the future?
Think about what’s happening in the industry. Is it a crowded market with lots of competitors? If so, what is this company doing differently?
Compare that to the company's strategy. Do you think it will be able to adapt and thrive over the next 10 years? How about 50 years?
Look at who’s leading the company. What type of experience and skills do these people have?
The PDS will sometimes include an escrow arrangement. This outlines how long some existing shareholders are required to hold their shares before they can sell them. If several shareholders plan to sell a large portion of their shares as part of the IPO, look into why they might be doing so.
While IPOs give you the opportunity to invest in a company before it lists, as with any investment, there are also associated risks. You should consider your risk appetite, and look at how these shares might fit within your wider investment strategy and portfolio.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.