Interestingly Perceptive Octopus?
Have you ever been in a conversation when someone has mentioned the acronym IPO, and you just nod willingly despite having no idea what they are talking about?
I have, I went to the bathroom, Googled it and found out. You’ll be pleased to know it’s not too hard to get your head around.
However, you may be disappointed to know that it has nothing to do with an octopus.
IPO stands for ‘initial public offering,’ and it refers to the first time a
company offers shares of its business to the public.
This is done on a stock exchange like the ASX or NASDAQ (US stock exchange), and allows anyone to buy a share in that company. This is also known as ‘going public.’
It's the process of bringing a company from private shareholders to public, where shares are traded on the open market.
Why would a company perform an IPO?
An IPO is a great way for a company to raise capital so they can grow or expand their business.
Let’s say John down the street owns an ice cream truck. His ice cream truck is doing quite well, so he wants to purchase a second.
Unfortunately for John he doesn’t have enough money to buy a new truck and doesn’t want to take on any debt. So John decides to sell shares of his company to make money for his business expansion.
His business is worth $300,000; he then decides to split that into 50,000 shares, with each share worth $6.
25,000 shares (50%) are then sold to the public and John keeps the other 25,000 (50%), so he still controls the business. John has just performed an IPO and raised $150,000 in the capital. He can now purchase his second truck.
Is it really that simple?
No.
I mean, there are probably other ways of financing John's ice-cream business other than setting up a publically traded company.
But that is the general idea.
How does a company do this?
Before a company lists, it will often go to an investment bank like Goldman Sachs or JPMorgan to conduct the process.
These banks manage everything from valuing the business, preparing the legal
documents and finding investors to buy the initial shares.
They also establish a value for the business.
In order to list on the stock exchange, John’s ice cream business becomes a public company.
What happens now?
Once a company is public it is now at the mercy of the market.
This comes with many pros and cons:
Pros
- John’s Ice Cream obtains a large, diverse group of investors to raise capital.
- Help give the company a lower cost of capital
- John’s company’s exposure, prestige, and public image will be increased, which can assist the company’s sales and profits.
- IPOs tend to raise the largest amount of money for the company compared to other options
Cons
- John’s Ice Cream is now required to publish financial, accounting, tax, and other business information, which can be helpful to competitors.
- The company will take on high legal, accounting, and marketing costs, many of which are ongoing.
- There is a risk that required funding will not be raised if the market does not accept the IPO price, sending the stock price lower right after the offering.
- John may experience a loss of control and stronger agency problems due to new shareholders, who obtain voting rights and can effectively control company decisions via the board of directors.
I hope next time someone mentions the term IPO the feeling of embarrassment and anxiety won’t consume you like it did the first time (maybe that was just me).
If you want to learn more about investing and the stock exchange, check out some of the other investment posts on our blog.
