IPO Basics: How Companies Go Public and What Investors Should Know

Introduction

An Initial Public Offering, or IPO, is the process where a private company sells shares to the public for the first time. Going public gives the company access to public capital, and it creates a market price for ownership that anyone can buy or sell.

IPOs matter to investors because they create exciting opportunities and unique risks. You may see big gains on day one or steep losses in the months after. Ever wondered why some IPOs skyrocket on day one while others fade? Should you buy into the hype when a buzzy new stock lists?

This guide will walk you through why companies choose to IPO, the key steps in the IPO process, what happens on the first trading day, how to evaluate a newly listed company, and practical tips for beginners. By the end, you should feel comfortable reading the filing documents, understanding the price mechanics, and deciding whether and how to participate.

Key Takeaways

• An IPO lets a private company sell shares to the public to raise capital, reward early investors, or create a public currency for acquisitions.
• The IPO process includes filing an S-1, hiring underwriters, a roadshow, price setting, and then the first day of trading.
• Retail investors often have limited access to IPO allotments, so many buy on the open market after listing instead.
• IPOs are often volatile, with first-day pops common and additional risk at lock-up expiry when insiders can sell shares.
• To evaluate an IPO, read the S-1, focus on revenue, margins, cash flow, business model, and valuation versus peers.
• Consider strategies like waiting for the initial noise to settle, using limit orders, or dollar-cost averaging to manage risk.

Why Companies Choose to Go Public

Companies IPO for several reasons. The most common are to raise capital for growth, provide liquidity for early investors and employees, and to gain a publicly traded currency for acquisitions. Public status also raises a companys profile and can improve access to credit.

Going public is expensive and requires ongoing disclosure, so companies usually IPO when they need substantial capital or want to reward early backers. For example, $ABNB went public in 2020 partly to raise growth capital and give early investors a way to realize gains. Each company weighs the benefits and costs differently.

When you look at an IPO, consider the companys goals and how the new capital will be used. Is it for product development, marketing, paying down debt, or expanding internationally? That matters to long-term investors.

How the IPO Process Works

The IPO has a sequence of steps, and understanding them helps you interpret news and filings. Below are the main stages to watch for and what each one means for investors.

1. Filing the S-1 with the SEC

A company starts by filing an S-1 registration statement with the Securities and Exchange Commission. The S-1 contains audited financials, business description, risk factors, and use of proceeds. Reading the S-1 is one of the best ways you can evaluate an IPO before it trades.

Pay attention to revenue trends, profitability, cash flow, and the risk factors section. The S-1 also shows the proposed number of shares and the selling shareholders, which tells you how much insider ownership will remain.

2. Choosing underwriters and the roadshow

Investment banks, called underwriters, help structure the deal, set the price range, and market the offering to investors. The company and underwriters run a roadshow where they present to institutional investors to gauge demand. Strong institutional interest often leads to a tighter pricing range or a larger offering.

Retail investors are rarely part of the roadshow discussions. Institutional demand during this period heavily influences the IPO price and allocation of shares.

3. Pricing and allocation

On pricing day the underwriters set the final IPO price using book building. That price balances how many shares the company wants to sell with investor demand. After pricing, the shares are allocated. Large institutional investors and favored clients typically receive most of the allocations.

Retail access to IPO shares varies by broker. Some brokers offer IPO programs that give clients limited allocations. Many retail investors instead plan to buy on the open market after the stock begins trading.

What Happens on the First Day of Trading

The first day of trading is when the IPO price meets the open market. Trading can be chaotic and volatile because market makers, retail investors, and institutional traders all respond to the new public price.

There are two common outcomes. One, the stock opens above the IPO price and often jumps further, a first-day pop that can be 10 percent to over 100 percent for hot deals. Two, the stock opens below the IPO price and can drift lower. Historically, new US IPOs have shown average first-day gains in the low double digits, but this varies widely by year and sector.

Remember that a strong first-day pop does not guarantee long-term success. For example, $SNOW priced at $120 in 2020 and opened sharply higher that day, delivering large first-day gains. That excitement reflected strong demand, but the post-IPO trading path for any company depends on future performance and market conditions.

Order Types and execution

If you buy on the first day, you can place a market order or a limit order. A market order may fill quickly but at an unpredictable price if volatility is high. A limit order sets the price youre willing to pay, protecting you from sudden spikes, but it may not execute.

Risks and Volatility Around IPOs

IPOs carry specific risks you should understand before participating. The three most important are valuation risk, limited operating history as a public company, and concentration of insider ownership.

Lock-up periods are another practical risk. Typically lasting 90 to 180 days, lock-ups prevent insiders from selling immediately. When the lock-up expires, a wave of insider selling can increase supply and push the stock lower. You should factor this timing into your plan.

Thin float can magnify price moves. If only a small percentage of shares are available to trade, small buy or sell orders can move the price a lot. That creates opportunities, but it also creates sharper downside risk.

How to Evaluate a Newly Listed Company

When an IPO draws your attention, approach it like any other investment. Gather facts, check the numbers, and compare the company to established peers. Here are practical steps to follow.

1. Read the S-1 and prospectus to understand the business model and risks. The risk factors section is often long, but it shows what management and lawyers are most worried about.
2. Check financials: revenue growth, gross margins, operating margins, and cash flow. High growth with widening losses is common in tech IPOs, but know how sustainable the growth is.
3. Compare valuation: use price to sales P/S for loss-making companies, or price to earnings P/E if profitable. Compare these to public peers to see if the IPO premium is justified.
4. Assess the competitive moat: does the company have clear advantages like network effects, low-cost production, or strong brand loyalty?
5. Look at insider ownership and lock-up schedules. High insider ownership aligned with long-term incentives can be positive, but large planned insider sales could be a red flag.

For example, if $EXAMPLECo reports $200 million in revenue with 50 percent year-over-year growth but a P/S ratio twice that of peers, you should ask why investors are paying a premium and whether those growth rates will persist.

Practical Tips for Beginners

Here are actionable ways you can take part in IPOs while managing risk. You dont need to chase every new listing to benefit from them.

• Consider waiting 1 to 3 months after listing. The initial volatility often settles and more trading data becomes available.
• Use limit orders, especially on the first day, to avoid paying a runaway price on a market order.
• Think about position size. Limit any single IPO position to a small percentage of your portfolio so volatility has limited impact.
• Consider dollar-cost averaging if you want exposure but are unsure about timing. This spreads risk across several purchases.
• If your broker offers IPO allocations, only participate if youve done your homework on the company and are comfortable with the risks.

Real-World Examples

Real examples make the mechanics clearer. Two well-known recent IPOs illustrate different outcomes.

$SNOW and $ABNB

$SNOW Snowflakes IPO in 2020 priced at $120 and opened much higher on the first day, reflecting intense demand for cloud software names. The strong listing rewarded early investors but also set high expectations for future revenue growth.

$ABNB Airbnb priced at $68 in late 2020 and opened above $140. The first-day pop rewarded public demand, but Airbnbs longer-term performance depended on travel trends returning after pandemic restrictions eased.

Hypothetical example to show math

Imagine you get an IPO allocation and buy 50 shares at the $20 IPO price, costing $1,000. The stock opens at $30 on day one. Your paper gain is $500 or 50 percent. If you sell immediately you lock in that gain, but you may pay higher taxes on short-term gains. If you hold and the stock falls to $15 after lock-up expiry, your position would be worth $750 and youd have a 25 percent loss from your entry. That simple math shows why entry price and timing matter.

Common Mistakes to Avoid

• Chasing first-day pops: FOMO can lead you to buy at inflated prices. How to avoid it: set a limit price or wait for initial volatility to calm down.
• Ignoring the S-1 and fundamentals: Buying on hype alone is risky. How to avoid it: read key sections of the filing and check revenue and cash flow trends.
• Overconcentration: Putting too much of your portfolio into one hot IPO increases risk. How to avoid it: cap position sizes and diversify across sectors.
• Not accounting for lock-up expiries: Large insider sales can pressure the stock. How to avoid it: know the lock-up date and consider reducing exposure ahead of it.
• Using market orders in thin markets: You may get filled at an unfavorable price. How to avoid it: use limit orders especially on the first trading day.

FAQ

Q: How can I get IPO shares at the offering price?

A: Retail access to IPO allocations depends on your broker and account type. Some brokers offer IPO programs with limited allocations to retail clients. Typically, most shares go to institutional investors. If you dont receive an allocation, you can buy the stock on the open market after it begins trading.

Q: Are IPOs worth the risk for a beginner?

A: IPOs offer opportunity but also heightened risk. For beginners, it can be wiser to learn the companys business, wait for initial volatility to settle, and limit position size. You can also gain exposure later if the company becomes more established as a public firm.

Q: What is a lock-up period and why does it matter?

A: A lock-up period is usually 90 to 180 days during which insiders cannot sell shares. When the lock-up expires, insiders may sell, increasing supply and potentially lowering the stock price. Knowing the lock-up schedule helps you plan timing for buying or trimming a position.

Q: Should I use valuation metrics for unprofitable IPOs?

A: Yes, for loss-making companies compare price to sales P/S, revenue growth rates, and unit economics. Look for a clear path to profitability and compare the IPO valuation to similar public companies to see if it’s justified.

Bottom Line

IPOs are an important part of the market ecosystem, offering companies capital and investors new opportunities. They also carry unique risks like volatility, valuation uncertainty, and insider selling after lock-up periods. You should read the S-1, focus on fundamentals, and be cautious about buying into day-one hype.

If you want to participate, consider practical steps: use limit orders, control position size, consider dollar-cost averaging, and pay attention to lock-up expiries. At the end of the day, treating IPOs like any investment and doing your homework is the best way to participate responsibly.