Initial Public Offering (IPO)

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Definition of an Initial Public Offering (IPO):

An initial public offering (IPO) occurs when a company offers its shares to the public for the first time.

Detailed Explanation:

Assume a privately held company has experienced success and would like to grow, but the cash generated by the business is insufficient to finance its growth. The management may choose to have an initial public offering (IPO) to obtain the capital it needs. IPOs are issued by privately held companies that want to sell shares to the public for the first time. Management may choose to sell to the public because it cannot find enough investors privately. Publicly traded securities are more liquid than privately held stock, making it easier to raise large sums in the future. Normally companies hire an investment banker to help them through the process of filing the paperwork, determining the share price, and marketing the shares. 

For example, Be Lazy, Inc. is owned by George. George has developed a robot, Robo Friend. The demand for Robo Friends has grown beyond the capacity of Be Lazy's factory. George needs $10 million to expand Robo Friend's production and distribution channels. George is willing to sell just under half his interest in Be Lazy to expand, but he wants to retain a controlling interest in Be Lazy. George and his investment banker choose to issue 2 million shares at $10 a share. George retains 1,000,001 million shares and sells 999,999 shares. George sells fewer shares than he retains because he wants a controlling interest in his company, and he needs to own over 50 percent of the shares to maintain control. 

Investments in IPOs can be very risky. Normally, these companies are young growth companies. Financial reports are limited because privately held companies are not required to publish as detailed financial statements as publicly held companies. Frequently, management’s track record does not live up to an investor’s future expectations, and the share prices decline shortly after they are issued. This was evident in the dotcom era of the late 1990's when speculators invested in internet start-ups. Many companies had not earned a profit and had few assets to support the stock, yet prices increased fueled by what Alan Greenspan termed, “irrational exuberance”. Eventually the bubble popped on many of the dotcom stocks, and prices fell. 

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