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 expansion. The management may choose to use an initial public offering (IPO) to obtain the capital it needs. Privately held companies issue IPOs when they want to sell shares to the public for the first time. Management may choose to sell to the public because it needs help finding enough private investors. Publicly traded securities are more liquid than privately held stock, making it easier to raise large sums in the future. Companies typically hire an investment banker to help them through the process of filing the paperwork, determining the share price, and marketing the shares.

For example, George owns Be Lazy, Inc. and has developed a robot called Robo Friend. The demand for Robo Friends has grown beyond the capacity of Be Lazy’s factory. Be Lazy needs $100 million to expand Robo Friend’s production and distribution channels. George is willing to sell just under half his interest in Be Lazy to raise the necessary funds, but he wants to retain a controlling interest in the company. George and his investment banker decide to issue 20 million shares at $10 a share. George retains 10,000,001 shares and sells 9,999,999 shares. He sells fewer shares than he retains because he wants to maintain control of his company, which requires ownership of over 50 percent of the shares.

Investments in IPOs can be very risky. Typically, 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, the management’s track record does not live up to investors’ future expectations, and the share price declines shortly after they are issued. In the dot-com era of the late 1990s, many speculators invested in internet start-ups. Many of these companies had not earned a profit and had few assets to support the stock prices. Yet, prices increased fueled by what Federal Reserve Chairman Alan Greenspan termed “irrational exuberance.” Eventually, the bubble popped on many dot-com stocks, and subsequently, their prices fell. 

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