Definition of an IPO

An initial public offering (IPO) refers to the process by which a company sells its shares to the public for the first time. In an IPO, a privately owned company lists its shares on a stock exchange, such as the New York Stock Exchange (NYSE) or Nasdaq, making them available for purchase by the general public. This process, often called "going public," allows companies to transition from private to public ownership.

Companies pursue IPOs to raise capital for paying off debts, funding growth initiatives, or increasing their public profile. Additionally, IPOs enable company insiders to diversify their holdings or sell private shares to create liquidity. Both startup companies and long-established businesses can decide to go public.

Types of IPOs

There are two primary types of IPOs: Fixed Price Offerings and Book Building Offerings. Below is a detailed explanation of each:

Fixed Price Offering

In a fixed price IPO, the price is predetermined and remains constant throughout the offering process. However, the final price may only be revealed once the IPO is live. Companies consider various factors, such as market conditions and investor demand, to determine the fixed price. Investors must pay the full fixed price to participate.

It’s important to note that the IPO price may differ from the company’s opening trading price on the first day. For instance, Airbnb (Nasdaq: ABNB) priced its IPO shares at $68, but the stock opened for trading at $146 on its debut.

Book Building Offering

In a book building IPO, the company provides a price range, known as the price band, which includes a floor price (minimum) and a cap price (maximum). This structure allows investors to bid for shares within the specified range.

During the bidding process, investors indicate how many shares they want and the price they are willing to pay. Once the bidding period closes, the company determines the final offer price based on demand and investor bids.

Although fixed price and book building offerings are the most common types of IPOs, additional categories may exist depending on how a company chooses to go public.

Key IPO Terms

Understanding IPO-related jargon is essential for investors. Below are some key terms:

Common stock: Units of ownership in a public company that typically entitle holders to voting rights and dividends. When going public, a company offers shares of common stock for sale.

Issue price: The price at which shares of common stock will be sold to investors before the IPO. Commonly referred to as the offering price.

Green Shoe: Part of the underwriting agreement which, in the event the offering is oversubscribed, allows the issuer to authorize additional shares (typically 15%) to be distributed by the syndicate; also called the overallotment option.

Preliminary prospectus: A document created by the IPO company that discloses information about its business, strategy, historical financial statements, recent financial results and management. It has red lettering down the left side of the front cover and is sometimes called the “red herring.”

Price band: The price range in which investors can bid for IPO shares, set by the company and the underwriter. It’s generally different for each category of investor. For example, qualified institutional buyers might have a different price band than retail investors.

Underwriter: The investment bank that manages the offering for the issuing company. The underwriter generally determines the issue price, publicizes the IPO and assigns shares to investors.

Road Show: Also called the “dog and pony show,” a tour taken by a company preparing for an IPO to attract interest in its securities; attended by potential buyers, including institutional investors, analysts, and money managers by invitation only—members of the media are forbidden to attend.

Offering Date: The first day a security is publicly offered for sale.