How Does an IPO Work?

An initial public offering is the process of structuring a firm's shares for sale, establishing stakeholders, and establishing regulatory compliance chiefly centered around financial disclosures and transparency. Most of this process exists to protect the general public from purchasing shares in fraudulent companies.

When a company reaches a stage in its growth process where it believes it is mature enough for the rigors of SEC regulations along with the benefits and responsibilities to public shareholders, it will begin to advertise its interest in going public.

While the full process of an IPO involves a significant amount of both legal and accounting detail, here is the general framework:

Hire an Underwriter

IPO teams are formed comprising underwriters, lawyers, certified public accountants (CPAs), and Securities and Exchange Commission (SEC) experts.

The firm hires an underwriter, almost always an investment bank, to advise and fund the IPO. This bank will typically approach institutions and investors to create initial interest in the IPO in what is called the "road show" and will help with the disclosures and regulatory process.

The underwriter may also guarantee the initial public offering by purchasing the company's entire offering at an agreed-upon price, then selling that stock publicly itself. This is called a firm commitment. The alternative is a best efforts agreement, in which the underwriter sells the initial shares but does not provide any financial guarantees.

Financial Auditing

The company also hires a third-party accounting firm to conduct a complete audit of its finances.

The company, aided by its underwriter, assembles SEC registration documents. These include a prospectus, which is circulated to all potential investors, and private filings, which are for the SEC's eyes only. The registration documents include detailed financial information (including the third-party audits), information on the company's management, its potential liabilities, private share ownership and its business plan.

SEC Due Diligence & Approval

To register an offering, a company files a registration statement with the SEC, typically using Form S-1. Some offerings may involve other registration statement forms. The S-1 Registration Statement is the primary IPO filing document. It has two parts—the prospectus and the privately held filing information. The prospectus is the offering document describing the company, the IPO terms and other information that an investor may use when deciding whether to invest.

The S-1 includes preliminary information about the expected date of the filing. It will be revised often throughout the pre-IPO process. The included prospectus is also revised continuously.

The SEC will conduct due diligence to ensure that all information in the registration documents was accurate and complete.

After the SEC approves the filing the prospectus is circulated to potential investors and a date for the IPO is set. If the company and the underwriter have not yet agreed upon an initial price or quantity of shares, they do so now.

Marketing & Updates

Marketing materials are created for pre-marketing of the new stock issuance. Underwriters and executives market the share issuance to estimate demand and establish a final offering price. Underwriters can make revisions to their financial analysis throughout the marketing process. This can include changing the IPO price or issuance date as they see fit.

Companies take the necessary steps to meet specific public share offering requirements. Companies must adhere to both exchange listing requirements and SEC requirements for public companies.

Public Sale

Once these steps above have been met, the stock is issued for public sale.

Profit from the sale of shares depends on the agreement between the company and its underwriter. If they made a firm commitment, then all of the money for each share sold in an IPO goes to the underwriting bank. If not, the company and its shareholders get the money directly.

During this process the company will also decide how much control it will put up for sale. Contrary to popular belief, a company does not have to post 100% of its equity during the initial public offering. It can sell as little or as much control of the firm as it chooses.

Post IPO

Going public can provide companies with a huge amount of publicity. While going public might make it easier or cheaper for a company to raise capital, it complicates plenty of other matters. There are disclosure requirements, such as filing quarterly and annual financial reports. They must answer to shareholders, and there are reporting requirements for things like stock trading by senior executives or other moves, like selling assets or considering acquisitions.

Once a company has gone public it gains ongoing disclosure requirements regarding its finances, taxes, liabilities, business operations and more. This is often seen as one of the chief downsides to an IPO along with handing over control of a portion of the company. It is also the consequence of an initial public offering; once a firm is in ongoing compliance with public disclosure requirements, a subsidiary offering is far less significant.