Initial public offering (IPO)

What is an IPO?

An initial public offering, or IPO, is a company’s first sale of stock to the public. Before an IPO, a company is considered a private company, but afterward, its shares can be traded on an exchange. Also known as “going public,” the IPO is a company’s attempt to raise capital, but it may also reveal that a company’s valuation is wrong and cause its stock price to drop.

Deeper definition

Ownership of a company is determined by stock. As a private company, the stock is owned by a small group of shareholders and is not offered to anyone else outside the company. In an IPO, those shares are either sold to the public or more shares are added for that purpose, which is called dilution. If more shares are added, suddenly the original owners own a smaller proportion of the company, with the public making up the difference.

An investment bank determines the value of the company by purchasing the shares to be publicly traded first, assuming the risk. The company itself has already authorized the number of shares it has, so the valuation is divided up over the number of those shares. But once the stock goes to market, buyers and sellers determine the actual value, and the investment bank will attempt to sell what it can. This might result in a windfall for the company, but it could also lose value.

IPOs are sought to help grow the company, when the company’s funds aren’t enough to do it on their own, or investors may push for an IPO in order to convert their shares into cash. Sometimes a company isn’t worth anything in liquid cash before the IPO, which is common for tech startups that run on venture capital. In that case, the IPO is a way for the investors to recoup their investments in the absence of revenue.

Because filing an IPO requires revealing everything about a company’s finances, it may resist going public if it doesn’t want to disclose certain information. The company’s profitability might hinge on assumptions about its output and efficiency that it isn’t required to report as a private company. There are also expensive fees involved — upwards of millions of dollars. And the negative press from a poor showing can compound to hurt a company even more.

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IPO example

Saudi Aramco, the national oil-and-gas company of Saudi Arabia, has been planning an IPO for some time. Aramco is an old, conventional corporation, with billions of dollars in assets, but some shareholders are wary about what an IPO would reveal about the volume and quality of its oil reserves and how that could theoretically hurt its stock price. Estimates put its potential valuation at over a trillion dollars, but with oil prices so volatile, investors might balk at the opportunity. In the meantime, it’s looking for an exchange to host the sale.

Other Investing Terms

Prudent investor rule

Prudent investor rule is a term every investor should understand. Bankrate explains it.

Fiduciary rule

The fiduciary rule describes what a financial advisor can do with your money.

Repurchase agreement (repo loan)

A repurchase agreement is a short-term loan to raise quick cash. Bankrate explains.

Derivative

Derivative

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