What Is an IPO (Initial Public Offering)?

An initial public offering (IPO) occurs when a company goes public by offering stock shares to the public for the first time. After the IPO, the company's stock is traded on a stock exchange and subject to market forces.

Here's what you need to know about IPOs, including some potential downsides for business owners.

What Is an IPO?

An initial public offering is a process that a company goes through when it transitions from being a private company to a public one. As the name implies, the initial public offering is the first chance the general public has to invest in the company.

• Acronym: IPO

How Does an IPO Work?

There are two scenarios in which a company is likely to go public. First, a newer company may need additional capital to expand. Second, a growing, privately-owned company may have owners and investors who wish to cash in on their earlier investments.

How an IPO Is Created

A private company that wishes to go public via an IPO on Wall Street typically does so by finding an investment bank (such as Goldman Sachs or Morgan Stanley) that will underwrite the share issue. Through negotiations, the company and the investment bank decide on how many shares will be issued, the type of shares, and the issue share price. Depending on the agreement, the underwriter may guarantee the amount raised by purchasing some or all of the IPO shares from the company (and then reselling them to the public).

The investment bank prepares the IPO by submitting registration information to the Securities and Exchange Commission (SEC). Information submitted includes details about the share offering, financial statements, and corporate management information. The SEC performs background checks on the registration to make sure all the correct information has been disclosed in the submission.

After receiving SEC approval, the company and underwriter begin marketing the IPO to customers by issuing a series of prospectuses that describe the company and the share offering. At first, the shares are typically offered to larger institutional investors such as pension funds, life insurers, mutual funds, and others who can afford to purchase large blocks of shares (usually at a discounted price). Eventually, the shares are listed on a stock exchange and can be purchased by individual investors.

IPOs Are Not Always a Success

While an IPO can be financially advantageous for business owners, success is not guaranteed, and there may even be drawbacks for owners. First, you may not be able to get your money out as fast as you would like—investors may insist that all the money raised by the IPO be reinvested in the business, or that a portion of your shares is held in ​escrow for years.

Second, your ownership position may be seriously whittled down by an IPO. You may even lose control of the company. To avoid this, owners who wish to retain control of a company after an IPO can do so by issuing separate classes of shares that carry different multiples of the voting weight. For example, a company could weight IPO (Class A) shares with just 1/10th of the voting rights of the original private (Class B) shares. This way, even though an owner may lose majority ownership of the company, they could still control majority voting power.

There can be major drawbacks to investing in IPOs, as well. For most companies, the IPO process is the first time they'll open their accounting books. The lack of historical information makes it difficult to properly assess the share value of a company. Adding to the confusion, IPOs tend to be issued when market conditions are favorable, which means share prices could be buoyed by broad bullish sentiment on Wall Street.