What Is an IPO? How Companies Go Public

An IPO — initial public offering — is the moment a private company opens its doors to public investors by selling shares on a stock exchange for the first time. Before the IPO, the company's ownership is held by founders, employees, and private investors like venture capitalists. After the IPO, anyone with a brokerage account can buy a piece of the business.

IPOs generate enormous media attention and investor excitement — Airbnb surged 112% on its first trading day in December 2020, while DoorDash popped 86% that same week. The prospect of buying into "the next big thing" early is thrilling. But the reality of IPO investing is more complex — and less favorable for individual investors — than the hype suggests.

How the IPO Process Works

The company hires investment banks (called underwriters) to manage the IPO. The banks help determine the offering price, create the prospectus (a detailed disclosure document called an S-1 filed with the SEC), and drum up interest among institutional investors through a "roadshow" where management presents the company's story.

The offering price is set based on the company's financials, growth prospects, comparable valuations, and institutional demand. On IPO day, shares begin trading on the stock exchange. The opening trade price is often different from the offering price — sometimes dramatically so, depending on demand.

Most IPO shares at the offering price are allocated to institutional investors — hedge funds, mutual funds, and large clients of the underwriting banks. Individual investors typically can't buy at the offering price; they buy on the secondary market after trading begins, often at a price that already reflects the "IPO pop."

Why Companies Go Public

The primary motivation is capital. An IPO raises money that the company can use for growth — expanding operations, hiring, R&D, acquisitions, or paying down debt. Going public also provides liquidity for existing shareholders (founders and early investors who want to convert their private holdings into tradeable shares) and raises the company's public profile.

There's also a currency motivation: once public, the company can use its stock as currency for acquisitions and employee compensation. Stock options and restricted stock units are powerful recruiting tools, and publicly traded shares are far more attractive to employees than illiquid private equity.

The Risks of Investing in IPOs

Information Asymmetry

Before an IPO, the company was private — its financial details were not publicly available. The S-1 filing provides information, but it's written by the company's lawyers to present the business in the most favorable light possible while meeting legal disclosure requirements. You're working with limited history (often just 2-3 years of audited financials), no analyst coverage, and no track record as a public company.

Insiders — founders, employees, and early investors — know far more about the business than you do. They've been involved for years. You're making a decision based on a document designed to sell you shares.

Valuation Is Often Stretched

IPOs tend to happen during favorable market conditions when valuations are high — that's when companies get the best prices for their shares. By the time a company reaches your portfolio, you're often buying near the top of the cycle at a valuation that prices in years of optimistic growth assumptions.

Research consistently shows that IPOs underperform the broader market over three and five-year periods following the offering. The first-day pop benefits institutional investors who got the offering price; subsequent returns for public market buyers are often disappointing.

Lock-Up Expiration

Insiders and early investors are typically restricted from selling their shares for 90-180 days after the IPO (the lock-up period). When the lock-up expires, a flood of insider selling can push the stock price down — sometimes sharply. This creates a predictable selling pressure that informed investors watch carefully.

The Quality Investor's Approach to IPOs

We generally avoid IPOs entirely — or wait 12-24 months before considering them. The reasoning is sound: after a year or two as a public company, you have several quarters of financial data, analyst coverage, a visible competitive track record, and a stock price that has settled beyond the initial hype. The information advantage that insiders had at the IPO has diminished significantly.

The rare exception is an IPO where the business is already a proven, high-quality operation — strong ROIC, wide moat, consistent cash flows — and the offering price is reasonable. These situations are uncommon because most companies that fit this description are already valued aggressively by the time they IPO.

The best approach for most individual investors: let the excitement pass, wait for public data to accumulate, and evaluate the company with the same quality and valuation framework you'd apply to any other stock. If it's a genuinely great business at a reasonable price six months after the IPO, it'll still be a good investment then — without the IPO-day risk premium.