How Do IPOs Work?

Imagine you own a bakery that has been profitable for 10 years. You have a handful of private investors who helped you open locations, and they want their money back plus a return. Then a venture capital firm offers you $500 million for a 20% stake, which implies your bakery is worth $2.5 billion. You are not sure that is the right price. You are not sure you trust that one investor’s judgment. You are not sure you want that much outside ownership.

Now imagine instead that you list your bakery on the New York Stock Exchange and let the entire investing public bid on your shares. The market, with thousands of participants all with different views on your future, sets the price. That is what an IPO is. It is a mechanism for price discovery on something that has never been bought and sold before.

The short answer

An IPO is the process by which a private company sells shares to the public for the first time. The company hires investment banks to underwrite the offering, build a prospectus, gauge investor demand, and set an initial price. Once shares begin trading, the price is determined by buyers and sellers in the open market. The company receives the proceeds from the primary shares sold, while earlier investors sell their shares in the secondary offering. The entire process typically takes 12 to 24 months from decision to first day of trading.

The full picture

The decision to go public

Going public is not a casual decision. It commits a company to a level of financial disclosure, regulatory compliance, and shareholder scrutiny that private companies never face. Quarterly earnings calls, SEC filings, insider trading policies, and the constant pressure of public market valuations are permanent features of life after an IPO. Many founders describe it as going from being accountable to a handful of investors to being accountable to everyone.

The reasons companies do it anyway fall into a few categories. The most direct is capital: an IPO typically raises hundreds of millions to billions of dollars that the company can use for expansion, acquisitions, or paying down debt. The secondary offering that often follows within months of the IPO gives early investors a chance to sell some of their stakes and cash out. Being public also gives the company a currency for acquisitions (its stock) and a publicly verifiable valuation that can help with recruiting and partnerships.

The decision is usually triggered by a combination of growth milestones, investor pressure for liquidity, and favorable market conditions. Companies tend to IPO during periods of strong stock market performance and low interest rates, when investors are willing to take risk on growth companies.

Choosing investment banks

A company going public typically selects a lead investment bank, called the bookrunner, and a group of co-managers. The lead bank coordinates the entire process, builds the prospectus, manages the book-building process, and often buys any shares that are not sold to investors (the underwriting risk).

Banks compete for IPO mandates because they are extremely profitable. The typical underwriting fee is 7% of the money raised, which on a $1 billion IPO is $70 million. Banks also often receive stock warrants as part of their compensation, giving them upside if the stock performs well. This creates incentives for banks to price IPOs aggressively on the upside, because a successful IPO (one where the stock rises on the first day) generates more future business for the bank than a failed one.

The relationship between companies and their banks is supposed to be arm’s length, but in practice the banks have enormous power over how the IPO is priced and positioned. A bank that does not believe in the company’s valuation can quietly communicate that to investors, effectively killing the deal or forcing the company to accept a lower price.

The prospectus and the roadshow

Before shares can be sold, the company must file a registration statement with the SEC. This document, typically several hundred pages long, contains everything material about the business: financial statements, risk factors, use of proceeds, executive compensation, shareholder information, and a detailed description of the business and its competitive position.

The section most scrutinized by investors is the risk factors. Companies are required to disclose everything that could possibly go wrong, which results in prospectuses that read like a horror novel. You will find paragraphs about the risk of lawsuits, the risk of key employees leaving, the risk of competition, and the risk that the market for the product simply never develops. The SEC requires this disclosure as part of every registration filing. These disclosures are boilerplate but legally required, so investors learn to read between the lines.

Once the SEC declares the registration effective, the company hits the road. The roadshow is a series of presentations to institutional investors in cities around the world. The CEO and CFO present to pension funds, mutual funds, hedge funds, and sovereign wealth funds. They pitch the investment thesis, answer tough questions, and build enthusiasm for the deal.

This is where things get interesting from a price discovery standpoint. The banks gather indications of interest from investors: how many shares would you buy, and at what price? A large order at $50 per share tells the bank something different than a small order at the same price. The pattern of demand across the investor base is used to calibrate the final price range.

Setting the price

The price is set the night before trading begins in a process called price discovery. The banks and the company review the order book, look at the demand from different types of investors, and negotiate. There are three possible outcomes: the IPO is priced at the low end of the range (demand was weaker than expected), within the range (demand was in line), or above the range (demand was overwhelming, and the banks could have charged more).

The pricing is famously imperfect. [Research from the Journal of Finance consistently shows that IPOs tend to be underpriced on average](https://www. economist.com/finance-and-economics/2022/03/12/the-trouble-with-ipos), meaning the stock typically rises on the first day of trading. The intuition is that banks want to generate excitement and a positive first-day return to build a reputation for successful IPOs. The cost is borne by the company, which raised less money than it could have, and by the investors who got in at the IPO price and sold on the first day.

Some IPOs are dramatically underpriced. When Google went public in 2004, it priced at $85 per share and closed at $100.34 on the first day. Those who got allocation at $85 saw an immediate 18% gain. Others are dramatically overpriced. Facebook priced at $38 per share in May 2012 and fell 38% over the next four months before recovering.

The first day of trading

The opening bell on the first day of public trading is one of the most closely watched events in finance. Bids and offers are matched on the exchange floor or, more commonly now, through electronic matching. The first trade sets the opening price, and then the stock trades freely for the rest of the session.

The SEC recently introduced new rules aimed at reducing extreme first-day volatility in IPOs. The new rules require companies with market caps above $5 billion to file their prospectus well in advance and limit the ability of banks to allocate shares to their best corporate clients in ways that might pump up demand artificially.

The aftermath of an IPO is often less glamorous than the first day suggests. The lock-up period, typically 90 to 180 days, prevents company insiders from selling shares they received before the IPO. When that lock-up expires, a large number of shares suddenly become available. If the stock has risen significantly since the IPO, insiders may sell heavily, pushing the price down. This pattern is so reliable that traders specifically position themselves to short stocks ahead of major lock-up expirations.

Alternatives to traditional IPOs

The traditional IPO process has well-documented problems. It is expensive, slow, opaque, and prone to underpricing. In response, companies have developed several alternatives.

A direct listing (or direct public offering) skips the underwriters entirely. The company lists its shares on the exchange and existing shareholders can sell directly into the market. No new shares are created and no capital is raised in the traditional sense. Palantir and Slack both went public through direct listings. The advantage is that the price discovery is more organic, without the artificial scarcity created by a traditional IPO. The disadvantage is that companies do not receive any capital from the listing.

A SPAC merger (Special Purpose Acquisition Company) is a shell company that raises money from public investors and then merges with a private company, taking that company public in the process. The SPAC route became extremely popular in 2020 and 2021 before regulators cracked down on disclosures and deal quality. The process is faster and more certain than a traditional IPO, but it often results in higher fees and more dilution for the private company founders.

Why it matters

IPOs matter for several reasons beyond the obvious capital raising. They are a key mechanism by which the public markets absorb private companies. The largest companies in the world, including Apple, Microsoft, Amazon, and Google, all went through the IPO process. The returns from these early investments have created enormous wealth for founders, employees, and early investors.

For the broader economy, IPOs serve as a signal about the health of the startup ecosystem and the appetite for risk among investors. Years with many IPOs typically coincide with periods of strong economic confidence. Years with few IPOs often precede or accompany downturns.

For individual investors, IPOs are a reminder that the best time to invest in a company is often before it becomes famous. The first-day pop is real, but it is almost entirely captured by institutional investors who receive allocation, not by retail investors who buy afterward. Understanding how IPOs work helps explain why most individual investors should be skeptical of the investing advice that accompanies hot IPO coverage.

Common misconceptions

IPOs are a sign of success. Going public is often portrayed as the ultimate exit for a startup. In reality, the period immediately following an IPO is often the most operationally disruptive. The company must suddenly comply with a new layer of regulation, manage quarterly earnings expectations, and navigate the competing demands of thousands of new shareholders. Many successful companies have chosen to stay private indefinitely, including Stripe, SpaceX, and ByteDance, and have continued to grow and create value without going public.

The IPO price is the true value of the company. The IPO price is a negotiated number based on investor demand, bank recommendations, and market conditions at a single point in time. It is not an objective valuation. Many companies see their stock rise or fall by 30 to 50% in the months following an IPO as the market develops a more informed view of the business.

All IPOs are the same. The IPO for a mature profitable company like Visa or J.P. Morgan is fundamentally different from the IPO of a pre-revenue biotech company or a growth-stage software company. The valuation methods, the risks, and the likely outcomes are completely different. Treating all IPOs as equivalent is a recipe for misallocation of capital.

Key terms

Underwriting: The process by which investment banks guarantee the sale of shares and help set the IPO price. Banks buy the shares from the company at the agreed price and resell them to investors, bearing the risk if the shares do not sell.

Book building: The process of gathering indications of interest from institutional investors to help calibrate the IPO price range. Investors submit orders stating how many shares they want and at what price, and the bank uses this data to set the final price.

Lock-up period: A contractual restriction preventing company insiders from selling shares for a set period after the IPO, typically 90 to 180 days. This prevents a flood of selling from new public shareholders on the first day.

Secondary offering: A sale of additional shares by the company or existing shareholders after the IPO has already occurred. This dilutes existing shareholders and is a common event in the months following a successful IPO.

Direct listing: An alternative to an IPO in which a company lists its shares on an exchange without using underwriters or creating new shares. Existing shareholders can sell directly, but the company does not raise primary capital in the listing.

SPAC: A Special Purpose Acquisition Company, a shell company created specifically to merge with a private company and take it public without a traditional IPO process.