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A complete guide to initial public offerings (IPOs)

This article explains in-depth how initial public offerings (IPOs) work and how to gain exposure to private companies that are floating their shares on the stock market.

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What is an IPO?

An initial public offering describes the process of how a privately held company sells its shares on their chosen stock market, usually as part of a new stock issuance. This can be a fairly long procedure and it involves selecting underwriters, raising funding and marketing the process in order to raise investor attention.

When a company is registering for an IPO, it must meet the following criteria:

  • Strong company financials, such as revenue growth, future earnings visibility, strong cash flows and balance sheets.
  • It has a large addressable market.
  • Strong operational and compliance controls.
  • A competitive product or service with a well-established business plan.
  • Solid management team with a positive track record.

The figures for the above criteria are not set in stone and therefore listing requirements fluctuate between each individual stock exchange. The appeal for companies to go public is usually boosted by positive market conditions and supportive monetary policies.

What is the IPO process?

1. Selecting underwriters

A company that is planning an IPO will first select an investment bank that will act as the underwriter of the IPO. The investment bank should fulfil the following criteria: reputation, industry expertise and quality of research. The underwriter acts almost as a broker between the private company and the public to help with selling its initial issue of shares. The underwriter is also responsible for stabilizing the market after the stock has been issued. If there is an imbalance of orders on the initial day of trading, it will then purchase shares of the company at the offering price or below it to reduce the likelihood of the stock plummeting.

2. Choosing a stock exchange

The company must then choose a stock exchange on which to debut their newly public shares. This usually coincides with the country and industry that the company operates in. For example, the NASDAQ exchange is favoured by the majority of technology companies in the US, whereas the New York Stock Exchange is home to many long-standing blue-chip stocks​.

3. Setting an IPO offer amount

Following approval from the SEC, an offer price and effective date are set by the investment bank. This price is usually based on company fundamentals​ such as their financial performance and what is believed to be the intrinsic value of the company. It should also be priced reasonably to attract a substantial amount of investor attention. When the company goes public, the private shareholders’ shares will be valued at the same price as the public shares. This is usually at a higher value than before the IPO, so they could potentially profit from the relative returns by selling when the lock-up period ends.

4. Pre-IPO investing

A number of trading platforms specialise in pre- and upcoming IPOs, where you can browse and choose a stock to invest in before its future IPO is carried out. Once the company is public, however, you can trade it like any other share in the stock market, using financial derivatives such as futures, forwards and options contracts.

5. IPO lock-up period

After the company has gone live on the stock market, there is typically a period of 90-180 days where investors cannot sell their shares, which is referred to as the ‘lock-up period’. This usually applies to insiders such as the company’s founders and employees but can also include early investors. The point of a lock-up period is to prevent the stock price from falling if the market is overwhelmed with a large number of shares sold by insiders.

6. Secondary offering after IPO

Companies have the ability to raise even more capital in the future. A secondary offering after the IPO releases the sale of new stock to the public in order to raise more funds for operations. This, in turn, dilutes the percentage of individual ownership for the original investors, which can cause negative investor sentiment.

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IPO under-pricing reasons

An upcoming IPO’s share price is speculated on before it is actually announced, in relation to its overall revenue and income. However, an IPO can be under-priced if its sponsors cannot accurately predict the demand for the company’s shares.

Another theory is that some companies under-price their IPO below market value in order to attract a wider number of investors. A company that rises by a large amount on its IPO day may get a substantial amount of publicity, in turn further stimulating demand.

It is also speculated that IPOs are under-priced by their underwriters, who are typically large investment banks, in order to give their clients who are buying the stock a good deal and near immediate gains when the IPO goes live. This way, it ensures that the underwriter’s clients will be happy and investors will buy up all the shares of the company’s IPO, rather than having some shares left over.

What does the IPO market look like?

The IPO market has been rising in recent years, with 209 IPOs listed in 2020 alone. However, there has also been a rise of direct listings and SPAC mergers, where the latter accounted for an even higher figure of 248. Therefore, an increasing number of businesses are choosing to use a special-purpose acquisition company (SPAC)​ as it tends to offer a slightly cheaper and quicker process than a traditional IPO. Some of the largest stock market debuts in recent years were direct listings or SPAC mergers, such as Coinbase, Virgin Galactic and Palantir Technologies.

How to find IPO companies

Our hubpage for upcoming IPOs and new stocks covers a number of companies that are currently involved in the IPO process. See which shares have recently gone public on the stock market and will be available to trade with leverage on our Next Generation trading platform​.

When the IPO has passed, traders can decide whether to take a buy or sell position based on whether they think its share price will rise or fall. You can speculate on the underlying price movements of newly listed stocks using spread bets and CFDs​.

Follow our IPO news

You can also keep up to date with the latest news and analysis for the stock market, as we keep our online platform updated with daily reports and predictions from our professional market analysts. Alternatively, if you would like to see data from external news providers, our news and insights section offers free fundamental analysis stock reports from Morningstar and live updates on the share market from Reuters.

Interested in receiving notifications about IPO news? With our trading alerts feature, you can choose to receive breaking news alerts on your desktop device or mobile app, through either push notifications, email or SMS.

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How to buy pre-IPO stock

Before the IPO occurs, there is sometimes a private sale of a company’s shares before the stock is listed on the chosen exchange. These buyers are usually venture capitalists, as mentioned above, as well as private equity investors, hedge funds and other private investors that aim to profit from a stake in the company in the future. They will also be given a discount from the upcoming IPO price to attract a larger number of investors.

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What are the advantages and disadvantages of an initial public offering?

  • IPO fundraising can be very profitable. Many offerings bring in over $100m, which can help to finance research, marketing, new technology, employees and reduce overall debt. The money funded in an IPO can have a long-term effect on the company.
  • IPOs can benefit private investors. This is because many IPO companies will cause share premiums for their existing investors, so this can result in potential profits. Existing shareholders of a private company could include family, friends, and professional investors such as venture capitalists. These private equity investors help to finance companies with high growth potential in exchange for a stake in their equity.
  • IPOs can be a costly process. Although the money raised from an IPO appears advantageous for most, the transaction involves underwriting, legal, auditing and registration fees. Therefore, only select companies can afford to undergo an IPO in the first place.
  • IPOs can underperform upon debut. Past examples such as Deliveroo prove that reasonable company financials and investor sentiment doesn’t guarantee a successful IPO. The stock market can be a volatile place and share prices are constantly under scrutiny from analysts and investors alike, increasing pressure on the company.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.