The basics of an initial public offering

A stock IPO is a big step for any company, and it usually involves very large piles of cash. For most people, however, the ins and outs of an IPO are confusing.

The basic idea of an IPO

An initial public offering is when a company that has previously been privately held offers stock holdings publicly. An IPO is the day a company officially transitions from a privately held company held responsible only to the owners to a publicly owned company responsible to stockholders. An IPO also usually represents a huge amount of cash, because the company gets money for the control of the company that they are selling off. An initial public offering is, essentially, when a company sells control in order to raise money to use for business purposes.

How an IPO price is set

Before an initial public offering, a company is allowed to set the price for stock shares. However, once those stocks are offered on a public exchange, the company loses all control of the price of the stock. From that point forward, the only control a company can exert on its stock price is the behavior of the company, rather than the stock price itself. Before the IPO, however, the company usually goes around and “shops” its own stock to large investment companies, banks, and other large investors. Most of the stock of a company is usually spoken for at a particular price before the day of the initial public offering. Once the stock hits the public market, market forces determine whether the price should go up or down.

The importance of the IPO day

The day of the initial public offering is the day that the previously agreed upon purchases of the stock by large investors actually take place, and the money flows into the company. The IPO day is also the first day that private investors can decide to invest in a company and purchase stock. In short, the IPO day is the day that a company receives buckets of money and hands over control.

Should you buy in on an IPO?

An initial public offering can be a very tempting day to buy in to a stock. As an individual investor, however, buying in on IPO day may or may not be a good idea. Some stocks only go up in price from the IPO, but most experience some kind of volatility in the few days or weeks after an initial public offering. If you are 100 percent confident that a stock price will only be going up after the IPO, then it could be worth buying in. If not, then it could be worth waiting. Remember that an IPO is not a magic bullet; an IPO is simply the first time something is available.

Sources

Investopedia
Morning Star
How Stuff Works