What is an initial public offering (IPO)?

Under federal security laws, a startup cannot sell or offer shares, unless the transaction is regulated by the Securities and Exchange Commission (SEC.) Therefore, the IPO is the first batch of stocks your startup sells after the SEC approves it.

Initial public offering (IPO) meaning

An IPO is the process through which your startup turns into a publicly traded company by selling a portion of its ownership through shares or stocks. In short, the IPO allows the ordinary investor to buy stock in startups only available to big private investors.

While it’s every startup leader’s dream to take their business public, it’s often a challenging process that requires immense research and planning. This article covers everything you need to know about IPOs, so keep reading to learn how to take your startup public. 

How do IPOs work?

While going public is in every startup’s goals, it’s not as easy as it looks in the movies. An IPO attracts more public scrutiny over internal operations and there is often endless paperwork that you need to file to comply with the SEC, which oversees public companies. 

As a result, most startups hire underwriters, usually investment banks, to consult on the IPO and help set everything up. An underwriter will help your startup’s management schedule meetings with potential investors, create documents for existing investors, and set share prices for the IPO.

Once you’ve agreed on share prices for the IPO, your underwriter will distribute the shares to investors through a public stock exchange.

409a valuation vs IPO price

Startups often hire independent third-party companies to evaluate how much their common shares are worth at that point. The resulting valuation is 409a. If you conduct a 409a valuation regularly, you might be wondering whether the IPO price will match the 409a prices. In most cases, IPO share prices are higher than the 409a valuation share prices. However, the IPO could also match or fall below 409a valuations depending on the startup’s value at the time of the IPO.

Can you buy stocks before an IPO?

While it’s possible to buy stocks before an IPO, the option is generally not available for individual investors. Typically, buying stocks before an IPO is reserved for institutional investors, high-net-worth individuals, or startup insiders.

The most common IPO alternatives are direct listings and SPACs. Below is how they compare to IPOs.

Direct listing vs initial public offering

While IPOs and direct listings allow you to sell your startup’s shares, they differ in how you present the shares.

In an IPO, your startup will hire an investment bank to underwrite the offering and help sell shares to the public. You will typically issue new shares of stock to raise capital, and the investment banks will price and distribute the shares to the public.

On the other hand, in a direct listing, you will avail your existing shares to the public without involving investment banks or underwriters. This means that your startup will not raise any new capital through the offering. Instead, it will allow founders, employees, or other early investors to sell their existing shares.

Direct listings have become more popular in recent years, particularly among tech startups that have already raised enough private capital and don’t need to raise additional funds through an IPO. However, direct listings can be more complex and risky for investors, as there is no underwriting or price-setting process to ensure that the shares are fairly valued.

SPACs vs IPOs

A SPAC is a shell company that is created specifically to raise funds through an IPO with the goal of acquiring an existing startup and taking it public. The funds raised through the IPO are held in trust until the SPAC identifies a suitable target company to acquire.

Once the SPAC identifies a target startup, they merge, and the target startup becomes a publicly-traded company through the SPAC's existing listing. In contrast, an initial public offering forces your startup to create new shares that the new investors will buy in exchange for cash.

Although both SPACs and IPOs offer startups a way to go public, they have some critical distinctions to consider. SPACs are a quicker and more straightforward way for companies to go public, but they also carry more risks and uncertainties for the investors because the target startup may not perform as expected. IPOs, on the other hand, provide a more traditional and established route to going public, but they’re more time-consuming and expensive.

Advantages of initial public offering

There are several benefits of taking your startup public through an IPO. Below are the most significant ones:

• Reducing corporate debt: You can retire your startup’s debt through the IPO or subsequent share offerings. This allows you to focus your income on growth.
• Raising capital: Your startup will raise millions of dollars in its initial public offering. You can use this capital to grow in countless ways, including hiring staff, research, and development, or even acquiring other startups.
• Exit opportunity for early investors: Every startup has a few stakeholders who’ve invested time, funds, and other resources, hoping to create a successful company. Once the startup holds an IPO and becomes a public company, these investors can liquify some of their shares for huge payouts.
• You can use stock as a payment method: While startups can use their stock to pay debtors, publicly traded stock is a more acceptable currency. Therefore, after the IPO, you can use your startup’s stock to pay your employees.

Initial public offering (IPO): Key takeaways

An IPO allows the general public to invest in your startup. It also allows you to turn your stock into an acceptable currency and use it to pay debt and offer your employees stock options.

However, if your startup already has enough private capital, you can explore other alternatives like direct listing.

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Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.