An initial public offering (IPO) is the process by which a private company issues shares of its stock to the public for the first time on a stock exchange.
Mechanics of an initial public offering
Before an IPO, a company is privately held by founders and early investors. To raise capital for expansion or to allow early investors to sell their stakes, the company decides to sell ownership shares to institutional and retail investors. This transition requires regulatory approval from the financial authority in the company’s jurisdiction, such as the Financial Conduct Authority in the UK or the Securities and Exchange Commission in the US.
The company hires an investment bank to underwrite the offering. The underwriter evaluates the financials to determine the initial share price and the number of shares to issue. The underwriter drafts a prospectus, which is a legal document detailing the business model and financial statements. This document is distributed to potential investors to generate interest in the stock before it begins trading.
Once the regulatory body approves the prospectus, the stock is listed on a public exchange like the London Stock Exchange or the Tokyo Stock Exchange. On the day of the IPO, shares are allocated to buyers, and the stock begins trading on the open market. From this point forward, the share price fluctuates based on market demand, and the firm is subject to ongoing public reporting requirements.
Example
Imagine a private company called Trunk Tech that manufactures heavy-duty veterinary equipment for wildlife reserves. Initially, the founders and a small group of private investors own all the shares. Trunk Tech needs to raise capital to build a new manufacturing facility and decides to go public.
The company hires an underwriter and prices its IPO at 20 units of local currency per share, offering 10 million shares to the public. As fellow Elephants reviewing the prospectus, you read that the company has consistent revenue and you decide to buy 100 shares at the offering price. When the stock market opens on the day of the IPO, Trunk Tech shares become available for anyone to buy and sell. The capital raised from the 10 million shares goes directly to Trunk Tech, and the company is now publicly traded.