An initial public offering, or IPO, is the first time a company sells its shares to the public and lists them on a stock exchange. Before the IPO, the company's shares are held privately by its founders, employees and early investors. After it, anyone with a broker account can buy them. An IPO is a major step for a company, and it is also a major event for investors, because it is often the first chance to buy into the business at a price the company set.
IPOs attract a lot of attention. Some rise sharply on their first day, and some fall. This guide explains how the process works, what the documents tell you, why first-day moves are not a reliable guide to value, and what to check before you apply.
Why a company floats
A company lists for several reasons. It may need money to grow, to repay debt or to buy another business. Its early investors may want a way to sell some of their stake. A public listing can also raise the company's profile and make it easier to borrow or to pay staff with shares.
The reasons matter, because the company decides the timing. A company that lists when it needs cash may be in a weaker position than one that lists because the business is strong and the market is receptive. Ask what the money raised will be used for. The answer is in the prospectus.
How the process works
The process usually follows a set path.
- Appointment of advisers. The company hires a lead manager, often an investment bank or a brokerage, and other advisers for legal, accounting and regulatory matters.
- Due diligence and prospectus. The advisers examine the company, and the company publishes a prospectus, which describes the business, its finances and the risks.
- Price range or fixed price. The company sets either a fixed offer price or a price range.
- Book building. Institutional investors indicate how many shares they would buy at different prices, and the lead manager uses this to set the final price.
- Allotment. Shares are allocated to applicants. If demand is higher than the shares on offer, allocation can be by lottery or by a formula.
- Listing. The shares start trading on the exchange, and the market sets the price from then on.
The rules for retail investors vary. In some markets, small investors apply during a fixed window and are allotted shares by lottery when the offer is oversubscribed. In others, they buy through a broker on the first day of trading. Check the rules of the market you are in.
What to read in a prospectus
The prospectus is the most important document. It is long and dense, but a few sections matter most.
- The business description: what the company sells, to whom, and how it makes money.
- Risk factors: the risks the company itself identifies. Read these carefully, because they are written to show what could go wrong.
- Use of proceeds: how the money raised will be spent. Money spent on paying down debt or buying a rival is different from money spent on growth.
- Financial statements: revenue, profit, cash flow and debt for the last few years.
- Shareholders and control: who owns the company before and after the offer, and whether the founders keep control.
- Lock-up rules: when existing shareholders are allowed to sell. A large sale of shares after the lock-up can push the price down.
- Valuation: the price range and the reasons given for it.
Compare the financial figures with the risk factors. A company whose risk factors are long and specific is telling you where to look.
Why first-day moves do not tell you much
IPOs are often priced to sell, which means the lead manager may set the price below where the market will value the shares. This tends to make the first day strong for the buyers who received an allocation. Afterwards, the price often settles, sometimes below the first-day high and sometimes below the offer price.
A first-day gain is therefore not proof that the company is good value, and a first-day loss is not proof that it is bad. Both reflect the market's mood and the pricing decision at a single point in time.
A worked example
Suppose a company offers 10 million shares at 20 each, raising 200 million before costs. The prospectus says the money will repay 120 million of debt and fund 80 million of new stores.
Suppose the shares open at 24 on the first day. An investor who was allocated 500 shares paid 10,000 and sees a paper gain of 2,000. But the gain depends on selling. If the shares then fall to 17 in the following months, the same holding is worth 8,500, a loss of 1,500 on the price paid.
The important lesson is that the question is not the first-day price, but what the business will earn over the coming years. The prospectus tells you what the money is for, and the company's future results tell you whether it was well spent.
The risks
Limited history. A newly listed company has little public record of results and how it behaves in a difficult year. The prospectus shows the past few years, which may not be a full cycle.
Price set by the seller. The company and its advisers set the offer price, and their interests may differ from yours.
Lock-up expiry. When early investors are allowed to sell, the extra supply can push the price down.
Liquidity. Some new listings are thinly traded. A large sale can move the price a lot, and it can be hard to exit at a fair price.
Hype. IPOs often attract strong media attention. That attention can push the price above what the business is worth, and the reversal can be sharp.
Reading the price range
Many offers publish a price range rather than a fixed price. The final price is set after the book is built, and it can land at the top, the bottom or outside the range. Work out what the company is worth at each end of the range, using the earnings and the debt in the prospectus, and compare that with what you are being asked to pay. If the top of the range already looks expensive against the earnings, a strong listing day is not a reason to pay it.
Checklist before you apply
- Read the risk factors and the use of proceeds, not just the summary.
- Compare the financials with the valuation and the price range.
- Check who owns the company after the offer, and whether founders keep control.
- Note the lock-up dates and the size of shares that will become free to sell.
- Decide the price at which you would sell, and what you would do if the price falls below your purchase price.
- Limit the amount to money you can afford to lose. New listings are volatile.
Key takeaways
An IPO is a company's first sale of shares to the public, usually to fund growth, repay debt or give early investors a way out. The prospectus is the key document, and its use-of-proceeds, risk and lock-up sections matter most. First-day moves reflect pricing and mood more than value. Newly listed companies have limited history and can be volatile, so check the prospectus, decide your exit in advance and size the position to what you can afford to lose.
This guide is for general information, not financial advice. See the disclaimer.