Companies start out as privately owned with a few investors contributing the money to get the business started. As a business grows, it needs more money to fund expansion.
Companies can borrow some of the money, but it must be paid back with interest, which can slow growth down. If the company wants to expand beyond its local market, more capital will be needed - usually much more than the company could borrow.
The way many companies choose to raise this capital is by offering shares of its stock to the public. The initial public offering or IPO is a highly regulated event. The Securities and Exchange Commission (SEC) has a stringent set of guidelines that the company must follow during the process.
The SEC is the main regulatory agency responsible for monitoring the stock markets and securities industry. It must approve all IPOs and requires frequent and regular filings from publicly-traded companies.
It is a watchdog for investors to protect them against unethical investing practices. However, the SEC failed to protect investors from a variety of scams, including the fraud of various hedge funds and private wealth managers.
The SEC also failed to foresee and avert the melt-down of the financial markets beginning in 2008.
One of the documents the company produces is a prospectus, a legal summary of the business, its principal officers, its competitors and detailed financial records of the company's history to date. One major feature of the prospectus is a listing of all the risks involved in investing in the company.
Few people would invest in IPOs if they took the risks associated with a growing company seriously.
When all the legal paperwork is complete to the regulatory authorities' satisfaction, a date is set for the offering to the public. An investment-banking firm is responsible for bringing to stock to market and setting the initial price.
Investment banking firms are large financial institutions that handle the initial distribution of shares during an IPO. They sell shares to national and regional brokerage firms who in turn sell them to their best client.
Once shares are offered on the market, supply and demand for the IPO drives the price up or down.
IPOs have a mythical quality on Wall Street because of all the stories of stocks coming out and being bid up several hundred percent in price the first day. That was the case during the tech stock boom of the 1990s; however, with a few exceptions, that fever has died down in the recent past.
If you are a large client with one of the big regional or national brokerage companies you may have an opportunity to buy shares in an IPO before the general public. For most investors, however, the IPO passes through several hands before it is made available to the public.
In some cases, the IPO is strong enough that early buyers in the public markets can score a good price for the stock.
The market for IPOs is volatile and in some cases, more driven by hype than any realistic business plan. Too often, investors buy into the hype and pay an inflated price for the stock, which can't be sustained.
In other words, they may lose money.
On the other hand, many successful companies have mild IPOs, but go on to be very solid long-term investments.
The lesson is trying to score a quick profit with an IPO is very risky. Buy the company, not the hype, and you may get in early on a stock with long-term investment potential.