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Initial Public Offering (IPO)

As a start-up, many companies have shares concentrated in the hands of a few owners who are often involved in the day-to-day activities of the business as well. As it grows, a company will often look for additional financing. This financing can come from different sources - increased investment from its current owners, new investors within the current owners' personal networks, venture capitalists, and even banks. The biggest jump is when the company’s management decides to raise new capital by issuing its common stock, for the first time, publically. An initial public offering means the company is going public: anyone can buy shares on an exchange and be an owner of the company. Big IPOs in the United States include those of Google and Facebook. Today, China is emerging as a major IPO market.

The main reason a company will go public is 1. To Raise New Capital to use for investment opportunities it would like to pursue. There are other advantages, however.

  1. Financial Status: With the addition of new equity, an IPO may also improve the company's financial status, allowing it to borrow more in the future.
  2. IPOs as a Marketing Event: More importantly, for many companies, the IPO is a marketing event which creates momentum for the brand, driving up both the price of its shares and the sales of its products.
  3. Increased Visibility: Similarly, even after the IPO, being a public company will provide greater visibility for the company's products and services.
  4. Stock-Based Compensation: Public company's can also provide stock- or option- based compensation packages for employees and executives, which is becoming increasingly popular as it is seen to help align employee interests with the interests of the firm.
  5. Liquidity for Owners: Being a public company also provides the company's owners with increased liquidity for their own shares, which allows them to spend their wealth.

There are also several disadvantages to going public which help explain why an IPO is such an important event in a company’s history.

  1. Loss of Control: Shares of the company can now be bought by just about anybody on an organized exchange. As new shares are purchased by the public, the proportion of the company owned by its existing shareholders will go down. This dilution means existing owners have less control.
  2. Regulation: The Securities and Exchange Commission has much stricter guidelines for reporting and disclosure for public companies. This is to protect public investors. An IPO also requires that the company draw up a prospectus that provides information to potential investors and that must be approved by the SEC.
  3. Costs: Underwriters are often involved in IPOs. Underwriters help price and sell the new securities, buying the securities themselves and reselling them (profiting on the difference in price, or the spread). The underwriting fees (spread), legal fees, and registration fees are often called flotation costs. Underpricing and other indirect costs are also associated with IPOs.

Misinformation between well-connected and average investors has raised significant concerns about how IPOs are managed. Underwriters are responsible for allotting stock from the IPO to clients, and often tip-off their favorite clients about hot IPOs. For an average investor who subscribes to buy stock from an IPO, the winners curse describes how if you do get all the stock you wanted, chances are that is only because connected investors knew it was overpriced and avoided it.

See also: Issuing Equity

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