Dylan Lewis: Hey! I'm Motley Fool editor Dylan Lewis. In this FAQ video, we're going
to be talking about IPOs and why a company would want to go public.
An IPO is an initial public offering, or the first time a company makes shares available
to the public for purchase. Before we get into the X's and O's of IPOs, it's helpful
to understand how businesses get funded. If you're running a business, you have a couple
of different ways to raise money. You can take on debt -- there, you would borrow an
amount of money and pay it back over time in installments, plus some interest.
This can take the form of a loan from a bank, or debt the company issues itself. Or, you can issue equity.
When you do this, you're making ownership of your company available,
and in exchange for that ownership, the new shareholders pay some amount of money.
You don't have to
make any interest payments, but you do have to share ownership of your business.
Now, companies can issue equity privately. And often, this is how early-stage companies
raise funds, meaning that they're making a deal with investment firms or angel investors
to exchange some percentage of ownership in their company for a large chunk of money.
If you've ever watched Shark Tank, you've seen this at play. Raising money privately
is helpful early on. The company doesn't have to publicly disclose as much information,
and management doesn't have to worry about market noise. But that shield comes at a cost.
It's harder for people who own shares in private companies to turn their shares into cash.
Because of this, eventually many large businesses will reach a point where they want to go public
and list shares on an exchange where they can easily be traded. If that's the case,
the company will go through an IPO. That means the company will work with an investment bank
like Goldman Sachs or JP Morgan. These banks will underwrite the IPO, meaning they
will determine a valuation for the company and buy shares from the company at a set price,
then distribute them and help the company file with the SEC and get listed on an exchange
like the New York Stock Exchange. This whole process often takes several months, and when
the shares finally list, the company will throw a big party. Sometimes the executives
will ring the opening bell at the stock exchange the company is listed on.
IPOs get a lot of buzz, but often it's better to stay on the sidelines as an investor.
Because IPOs are the public's first chance to buy into the company, there's often a lot of pent-up
demand to buy shares when they first become available. This leads to a lot of funky price
movements because the value is being dictated by short-term spikes in demand, not business results,
which are what actually drives stock prices over time.
Also, an important thing to remember: most of the time, the company is choosing when
it goes public, so they're going to do it at a time when it's advantageous for them
to do so. Think about it -- if you were going to sell a portion of a business you ran,
you'd want to get the most you could for it, right? So, you'd probably do it when business results
looked really strong. The same logic applies to IPOs.
At their core, IPOs have a couple of major players, and their incentives are all aligned.
First, you have the business. The money from the business selling shares to the investment
banks goes directly to the company, which gives them cash to work with. So, the company
wants to raise as much as it can. You'll often hear IPOs called a capital raising event.
Then you have the investment bank. The investment bank has bought shares from the company and
is usually selling them to big clients and high-net-worth individuals. The investment
bank wants to make sure it can sell what it bought, and it wants its valuable clients
to be able to make money on the shares so that they stay happy. So, they want to get
shares to price high and gain value short-term. Then you have early investors. Most private
companies have early investors -- think venture capitalists, big investment firms,
possibly angel investors. These folks have had their money tied up in the private company for a while,
and often are ready to sell their stake and make a return on their investment.
For them, IPOs are an exit opportunity. Lastly, you have founders and employees of the company.
Founders and early employees of the company that go public often have a lot of their personal
wealth tied into the business through shares that they've accumulated. For these folks,
IPOs are a liquidity event, meaning they give people the chance to convert stock into cash.
All these people generally want to maximize the value of the business around the time it IPOs.
It means the company raises as much money as it can, and it means that people exiting
their investments are getting top dollar for the shares they're selling.
There's nothing wrong with that, but those incentives, on top of overwhelming market demand,
can often cause shares to spike, then fall, after an IPO. For that reason,
it's often best for the average investor to wait a bit before buying into a company that has
recently gone public. Doing that gives time for the market to settle down, and it gives
investors the benefit of seeing a few quarters of business results, and seeing how management
handles the scrutiny of the public markets. Ultimately, those are the factors that decide whether
a stock is worth noting. Thanks for watching, guys! If you enjoyed
this video, we have plenty more like it coming. Hit subscribe down in the bottom right and
give us a thumbs up. If you have any questions on things I hit in the video, drop them in
the comments section below. We love getting ideas for future videos!