What Is an IPO — in Plain Words

What the letters mean, and what an IPO is

IPO stands for initial public offering.

Investor.gov, the SEC’s investor site, defines the term in its glossary entry “Initial Public Offering (IPO)”: “An initial public offering, or IPO, generally refers to when a company first sells its shares to the public.”

The SEC’s Investor Bulletin on investing in an IPO states the same idea this way: “Historically, an initial public offering, or IPO, has referred to the first time a company offers its shares of capital stock to the general public.”

FINRA’s Rule 5130 uses a matching term for the same offering. It defines “new issue” as “any initial public offering of an equity security as defined in Section 3(a)(11) of the Exchange Act, made pursuant to a registration statement or offering circular.”

Private before, public after

The company was private before the offering. The Bulletin puts it this way: “An IPO gives the investing public an opportunity to own and participate in the growth of a formerly private company.”

After the offering, the company is a new public company. The Bulletin says: “A new public company typically has no prior reporting history, and the information that can inform a decision to invest often can only be found in the prospectus.”

An IPO also starts a public trading market for the shares. The Bulletin says: “An IPO helps to establish a trading market for the company’s shares. In conjunction with an IPO, a company usually applies to list its shares on an established stock exchange, such as the New York Stock Exchange or NASDAQ.”

Public life also brings ongoing public reports. The Bulletin says: “The new public company will also be required on a going-forward basis to disclose certain information to the public, including its quarterly and annual financial statements on Forms 10-Q and 10-K.”

The registration statement and the prospectus

Under the federal securities laws, the sale has to be registered, or an exemption has to apply. The Bulletin states: “Under the federal securities laws, a company may not lawfully offer or sell shares unless the transaction has been registered with the SEC or an exemption applies.”

To register, the company files a paper with the SEC. The Bulletin says: “To register an offering, a company files a registration statement with the SEC, typically using Form S-1. Some offerings may involve other registration statement forms.”

The key part of that filing, for a reader, is the prospectus. The Bulletin says: “An important part of this registration statement is the ‘prospectus’ that will be used by the company to solicit investors. The prospectus is the offering document describing the company, the IPO terms and other information that an investor may use when deciding whether to invest.”

The Bulletin stresses reading it: “It is important to read the prospectus because it provides information regarding the terms of the securities being offered as well as disclosure regarding the company’s business, financial condition, management and other matters that are key to deciding whether the offering is a good investment.”

Two sections the Bulletin names are worth knowing by name. Risk Factors “identifies risks that the company’s management feels could significantly impact the company’s business, operations or performance, or an investment in the securities being offered.” Use of Proceeds “specifies what the company plans to do with the money it raises in the offering.”

SEC review is not an approval

SEC staff review the filing, but that review has limits. The Bulletin says: “Registration statements for IPOs are subject to review by the SEC’s staff to monitor compliance with applicable disclosure requirements.”

It also says what the review is not: “the review process is not a guarantee that a company’s disclosure is complete or accurate, and the staff does not evaluate the merits of any IPO or determine whether an investment is appropriate for any investor.”

And on the step that lets the sale go ahead: “the SEC’s declaration of effectiveness does not represent an approval of the merits of the IPO or an indication that the information disclosed is complete or accurate.” In the Bulletin’s words, “responsibility for complete and accurate disclosure lies with the company and others involved in the preparation of the company’s registration statement and prospectus.”

Where the public can read the filing: EDGAR

The filing is public. The Bulletin says: “A company undertaking an IPO discloses required information in the registration statement, typically on Form S-1. Form S-1 and its amendments, which are denoted as S-1/A, are filed with the SEC and publicly available through the SEC’s EDGAR database.”

The SEC’s own Search Filings page describes that system: “Enjoy free public access to millions of informational documents filed by publicly traded companies and others in the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.” EDGAR is short for Electronic Data Gathering, Analysis, and Retrieval.

The Bulletin adds a timing note for the final version: “After a company’s IPO registration statement has been declared effective, the company will typically file a final prospectus—usually identified as a 424B3 or 424B4 filing in the EDGAR database. The final prospectus generally includes information related to the final offering price that is not available at the time the preliminary prospectus is distributed.” It also advises: “you should check to make sure you are referring to the company’s most recent filing, because the contents of the prospectus may be revised during the course of the registration process.”

Who helps sell the shares, and how the first price is set

The Bulletin defines the sellers’ helpers in one sentence: “Underwriters are the investment banks that manage and sell the IPO for the company.”

On price, the Bulletin says the underwriters “typically will have obtained ‘indications of interest’ from prospective investors prior to effectiveness and will use this information to recommend a price for the shares to the issuer, who ultimately determines the price of the IPO.” The issuer is the company offering the shares.

It describes that first price as an estimate, not a market price: “the offering price reflects a negotiated estimate as to the value of the company.”

Lockup agreements

Investor.gov has a separate glossary page on this one part of an IPO. It says: “Lockup agreements prohibit company insiders—including employees, their friends and family, and large shareholders—from selling their shares for a set period of time after an IPO. In other words, the shares are ‘locked up.’”

It explains why the agreement exists: “Before a company goes public, the company insiders and its underwriter typically enter into a lockup agreement to ensure that shares owned by these insiders don’t enter the public market too soon after the offering.”

On length, it says: “The terms of lockup agreements may vary, but most prevent insiders from selling their shares for 180 days. Lockups also may limit the number of shares that can be sold over a designated period of time.” The Bulletin gives the same typical length for the related lock-up agreements it describes: a period of time, “typically 180 days.”

The terms are public, in the same filing described above. Investor.gov says: “U.S. securities laws require a company using a lockup to disclose the terms in its registration documents, including its prospectus.” And: “To find out whether a company has a lockup agreement, review the company’s IPO prospectus. You can find the prospectus online through the SEC’s EDGAR database.”

Risks, in the sources’ own words

The Bulletin states the general risk plainly: “By their nature, however, IPOs can be risky and speculative investments.”

It ties part of that risk to how new the company is as a public company: “A new public company typically has no prior reporting history.”

It also warns about the first price versus the trading price: “The offering price may bear little relationship to the trading price of the securities, and it is not uncommon for the closing price of the shares shortly after the IPO to be well above or below the offering price.”

On buying right after the offering, it says: “In addition, purchasing shares in the market immediately following an IPO can be risky.” It explains one reason: underwriters can support the trading price in the first few days, and “Once this support ends, the stock price may decline significantly below the offering price.”

On supply, it says the trading price “may be affected by a limited supply of shares in the market immediately following an IPO,” and that limited trading volume “can operate to drive the trading price of an issue steeply up because of the limited supply to meet the high demand.”

On lockups ending, Investor.gov says: “This is important information because a company’s stock price may drop in anticipation that locked up shares will be sold into the market when the lockup ends.” These are the sources describing what can happen in general. None of them is a prediction about any one company.

One FINRA rule about who can be sold a new issue

FINRA Rule 5130 is titled “Restrictions on the Purchase and Sale of Initial Equity Public Offerings.” Its general prohibitions begin: “A member or a person associated with a member may not sell, or cause to be sold, a new issue to any account in which a restricted person has a beneficial interest, except as otherwise permitted herein.”

In plain words: FINRA’s rule puts limits on sales of a new issue to accounts tied to the restricted persons the rule defines. The full rule, including its definitions and exemptions, is on FINRA’s site, linked below. This page does not try to restate the whole rule.

What this page does not cover

This page covers only what the sources below say about IPOs in general: what the letters stand for, a private company offering shares to the public for the first time, the registration statement and prospectus, SEC review and what it is not, reading the filing on EDGAR, underwriters and the offering price as the Bulletin describes them, lockup agreements, the risk wording the sources use, and FINRA Rule 5130’s opening prohibition. It does not give steps for buying shares in an IPO, it does not cover any one company’s IPO, and it does not say what any stock will do next. Those topics need their own official sources, read on their own.