An initial public offering (IPO) is when a private company begins offering stock shares to the public. "Going public," as it's typically called, can help growing companies generate more capital to fund their business goals.
It also presents a unique opportunity for investors. IPO stock can provide diversification and potential returns if shares eventually increase in value. Nothing is guaranteed, however, so IPO investing is considered a high-risk investment. Let's explore how an IPO works, what you can expect and how to invest in an IPO.
How Does an IPO Work?
Before an IPO can happen, the company must file a registration statement with the U.S. Securities and Exchange Commission (SEC). If approved, the SEC will declare it effective and the company will have to continue meeting SEC requirements going forward. Companies transitioning out of private ownership typically partner with a lead underwriter who can assist with the securities registration process. They can also rally together investment banks and brokerage firms that will eventually sell the IPO stock to investors.
Once these details are in order, the IPO will enter the market. Offering stock shares to the public can unlock funding for businesses. Meanwhile, investors who buy IPO stock gain a partial ownership stake in the company.
Facebook's IPO in 2012, for example, generated a record-breaking $16 billion. At the time, it was the largest tech IPO ever and the third-biggest IPO in U.S. history. Shares for Facebook's IPO were priced at $38. These days the company (now known as Meta) is trading at more than $163 per share, though prices were over $382 in the fall of 2021. Market volatility is real and stock prices are constantly in flux, but IPOs allow investors to get in early before shares potentially increase in value.
Returns on IPOs
IPO returns are never a sure thing. It's impossible to predict which companies will take off and which ones will ultimately underperform expectations. Uber is a prime example. The ride-hailing app made its much-anticipated IPO debut in May 2019 at $45 per share. It ended up closing its first day of trading down 7.6%. Its highest stock price to date was just over $60 in early 2021. It's now trading at around $21.
Investors typically buy IPO stock from companies they think will do well in the long run, but making that determination isn't always easy.
Nasdaq recently analyzed the performance of companies that moved forward with IPOs between 2010 and 2020. They found that three years after their IPO, nearly two-thirds of companies were underperforming the market. But 29% of IPOs went on to outperform the market—some in a very big way. The data found that the top 10% of these IPOs earned an average market-adjusted return of more than 300%.
In other words, returns can go either way. Your personal risk tolerance, investment timeline and financial goals can help you determine if IPO investing is right for you. If you decide it is, you'll likely have to meet eligibility requirements to invest.
How to Invest in an IPO
The year 2021 was particularly busy for the IPO market. Investment bank Renaissance Capital reported that almost 400 companies went public, which generated $142.5 billion. Things now appear to be slowing down. By the end of 2022's second quarter, only 21 IPOs had made their debut.
We mention this because securing IPO stock can be tricky, especially when there are fewer companies in which to invest. Underwriters generally partner with investment banks and broker dealers to bring IPO stock to the public. This means that individual investors are typically limited to brokerage firms that participate in IPO launches.
These firms usually require investors to meet internal requirements to buy in. You may have to hold a significant amount of assets, meet minimum trading frequency benchmarks and have a long-term relationship with the brokerage, according to Fidelity Investments. Even then, you may be out of luck if there simply aren't enough IPO shares to go around.
It's still possible for individual investors to get in on IPO stock, but wealthy or institutional investors—who can more easily buy up larger shares and may have a higher appetite for risk—might have first dibs.
The Bottom Line
An IPO brings a private company into public ownership. It can generate much-needed capital to fund all sorts of business goals and allows investors to explore new ways to diversify their portfolios—and hopefully net a worthwhile return. IPO investing can be competitive and isn't as accessible as investing in other securities, but it could be an option if you have an established relationship with a brokerage firm that participates in IPOs. Just be prepared to meet their internal requirements.
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