Originally published at robinhood library.

🤔 Understanding an IPO

An Initial Public Offering (IPO) is a company’s first time offering its stock for sale to the public. It’s a lengthy process in which investment banks usually help the IPO’ing company determine an appropriate price to sell its shares on the stock market — and it culminates with List Day, when the shares become tradable.

When a company IPOs, its stock becomes listed on the public investing menu for the first time. Media hype surrounding the event can make it tempting to purchase stock in recent IPO companies, but IPO investing can be like jumping into the deep-end — it may not be appropriate for new investors looking for stable or predictable investments. More information on investing in an IPO can be found in the SEC’s investor bulletin.

Why do companies list their stocks?

For many companies, an IPO is an opportunity to raise substantial new money to grow the business. “Going public” also makes shares more liquid, which means it’s easier for early shareholders, like founders and initial investors, to turn their shares into cash. Lastly, the stringent financial reporting requirements that come with going public can encourage stronger management practices that may benefit shareholders.

Pricing and listing stock in an IPO

The IPO process usually begins with the company hiring one or more investment banks to help it decide the initial price of its shares. The company then issues a preliminary prospectus and registration statement (or S-1) detailing its business model and plans for the funds raised.

After that, the company and its banks can host a roadshow to discuss the business model with institutional investors, analysts, hedge funds, and fund managers, who can provide an indication of interest in buying the stock. This helps the company and its bankers determine the share price.

With the initial stock price determined, the company makes available new stock to offer on stock markets. In exchange for its shares, the company receives funds paid by investors who have purchased shares.

After the IPO, its stock is freely tradable on the secondary market, and most investors (except certain company insiders with restrictions) can buy or sell shares as they please.

What happens on the day of an IPO?

Investing in any stock comes with risk of the share price rising or falling, and that is especially true on List Day. Shares begin trading in public markets, initially at the final IPO price, then freely based on demand by investors.

In the US, trading of stocks begins at 9:30am ET (when the market opens). But List Day trading for an IPO making typically does not begin until later due to pent-up demand and limited supply of shares. Once the trading does begin, investors can begin buying and selling the new company’s shares through your brokerage firm.

Are there risks to trading a recently listed stock?

There are risks to trading all stocks, especially stocks of companies that recently listed.

Hype can increase volatility:

• There’s often media attention surrounding an IPO, and statements by the company’s leadership or bank underwriters may be overly optimistic or pessimistic in the early days of trading. This heightened attention can increase volatility, meaning the share price may rise or fall by significant amounts on a single day.

Investment banks can protect the stock price:

• In the days following an IPO, the bank underwriters are allowed to protect the stock price from falling too much. They may even buy shares of the newly-listed company. Once this support ends, the stock price has the potential to fall below the offering price. Look for this kind of price support in a company’s IPO registration paperwork.

IPO stocks are considered speculative. An investor should read the prospectus carefully:

• Typically released to the public a few weeks ahead of the IPO, the prospectus is required paperwork filed by the IPO’ing company. It’s designed to give investors information that can help them decide whether the offering is a good investment, like the terms of the stock, disclosures regarding the company’s financial condition, risks that the company faces, and details regarding their business model.

Direct Listing: An alternative way to go public

Both IPOs and Direct Listings give individual investors access to invest in companies for the first time, but there are some key differences. Unlike an IPO, a Direct Listing doesn’t involve issuing new shares or raising new capital. This means there’s no investor roadshow, and fewer fees paid to investment banks by the stock-issuing companies.

Companies with strong brands that aren’t looking to raise new capital are generally attracted to Direct Listings.Their core need is the ability to list their shares publicly so early investors and shareholders can sell off their stakes — the Direct Listing can satisfy that, possibly more efficiently. Spotify’s 2018 Direct Listing is a well known example.