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All trading basics

What is an IPO?

Selling Stock

IPO is an acronym for Initial Public Offering. This is the first sale of stock by a company to the public. A company can raise money by issuing either debt (bonds, debentures and convertible debentures) or equity (shares, trust units, funds, etc). If the company has never issued equity to the public, it's known as an IPO.

Companies fall into two broad categories: private and public.

A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company: Just put in some money, file the right legal documents, and follow the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. Did you know that IKEA, Domino's Pizza, and Hallmark Cards are all privately held?

It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public."

Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. In Canada, public companies report to provincial regulators such as the Ontario Securities Commission and the Autorité des marchés financiers (in Quebec). In other countries, public companies are overseen by governing similar bodies. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market, like any other commodity. If you have the money, you can invest. The CEO may not approve of you, but there's nothing he or she could do to stop you from buying stock.

Why Go Public?

Going public raises cash, and usually a lot of it. Being publicly traded also opens many financial doors:

  • Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
  • As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.
  • Trading in the open markets means liquidity . This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.

Being on a major stock exchange carries a considerable amount of prestige. In the past, only private companies with strong fundamentals could qualify for an IPO and it wasn't easy to get listed.

The Internet boom changed all this. Firms no longer needed strong financials and a solid history to go public. Instead, IPOs were done by smaller startups seeking to expand their business. There's nothing wrong with wanting to expand, but most of these firms had never made a profit and didn't plan on being profitable any time soon. Founded on venture capital (VC) funding, they spent like mad trying to generate enough excitement to make it to the market before burning through all their cash. In cases like this, companies might be suspected of doing an IPO just to make the founders rich. In VC talk, this is known as an exit strategy, implying that there's no desire to stick around and create value for shareholders. The IPO then becomes the end of the road rather than the beginning.

How can this happen? Remember: an IPO is just selling stock. It's all about the sales job. If you can convince people to buy stock in your company, you can raise a lot of money. IPOs like this can be extremely risky.