Why Do Companies Go Public Through IPOs?

When a hot new IPO comes onto the market, the hype train starts. Whilst this is an important milestone, what really drives the decision to go public?

Sept. 9, 2020

Initial Public Offerings, or IPOs, often catch the headlines as every analyst and their dog weighs in on the nature of the offering. Yet, getting to this stage can be a long road of analysis, consideration, and valuation before opening up the proverbial gates. With several complex stages to be completed beforehand, why do businesses then make the decision to go public this way rather than directly listing or via a SPAC? 

What is an ‘IPO’? 

An IPO is when a private company becomes a public one by offering shares for public investors to buy. Private firms usually have a small number of company-related shareholders, such as the founders, staff, family etc. as well as professional shareholders like venture capitalists who help fund the company. The sum of these ‘inside owners’ make up what is known as ‘insider ownership’ in the company. When it does go public, the number of shareholders in the business should shoot up as investors such as me or you buy up an outstanding percentage of the company’s stock. 

An IPO is usually the next step taken by many private firms when growth starts to plateau. There are advantages and disadvantages to going public, but the two main reasons for opening the doors to the public are to raise capital and to put money into the prior shareholder’s pockets.

The advantages of IPOs

The advantages of an IPO can be many, but the main one is the obvious financial benefit. An IPO raises capital which, in turn, can allow a company to pay off its debts or fund research and development. For the private investors, the financial gain from an IPO is often used as an exit strategy, this is where venture capitalists tend to cash in on their pre-IPO investments. 

An IPO can also be a great marketing tool for a company. By increasing public awareness, it creates free publicity, causing an uptake revenue and/or market share. This then allows the newly public company to prove its worth to those first public shareholders, attracting more investors to buy its stock and driving the share price upwards. 

As for investors, buying at an IPO can be just as advantageous. The first day of trading is extremely important, and can pan-out particularly well for smaller, under-the-radar companies who’s IPO is the first time it enters the public consciousness. For example, Beyond Meat (NASDAQ: BYND) had an explosive IPO and its stock price climbed 170% within the first day. Media outlets then took it upon themselves to discuss Beyond Meat extensively, and within a few months Beyond Meat’s stock had grown by 859%. Of course, it did fall soon after this, but has remained far above its IPO price. For those who invested early, they would have made serious returns on their original investment. A word of warning however, volatility like this is not always a good thing as many IPOs become inflated due to hype and then come crashing down soon afterwards. 

Disadvantages of an IPO

On the other hand, the disadvantages can put many companies off going public. Again, one disadvantage is the financial aspect. In order to get to the IPO stage, a firm must acquire the services of an investment bank such as Goldman Sachs or Morgan Stanley who then guide the firm through the IPO process. The service given does not come cheap and can often cost up to 7% of the IPOS total sale price. 

Another disadvantage would be the loss of control. Once public, company directors no longer have full control, either due to the percentage of shares sold, or merely because of the extra strict scrutiny from regulators that require increased transparency including reports on the finances every three months. In some cases, leaders can become distracted due to these pressures, leading to a lack of direction. This is further exacerbated by the legal requirements in the U.S. to report quarterly earnings results, which can lead to short-term thinking.

So, what are the takeaways? 

As much as an IPO can be an asset to a company, it can also be a daunting prospect. For an investor the opportunity to get in early can be tempting, particularly with so much hype surrounding some of those historically big IPOs such as Alibaba or Visa.

If you are looking at an IPO as a potential investment then there are three important things to consider: 

  • Try not to get caught up in the hype, take a step back and look at its fundamentals.
  • Remember to think about your investment in the long term.
  • Invest in a company that you believe in, you will need this belief to keep you interested during the post IPO volatility that many businesses experience.

MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.