You might not know it from watching media coverage, but the basic purpose of an initial public offering of stock, or IPO, is not to get a big first-day "pop" that makes headlines. An IPO may enhance a company's reputation, but the primary purpose is to position the company for future success.
Shares of Ownership
An initial public offering is the first time a company can sell stock to the general public, as opposed to company insiders or private investors. Usually working through an investment bank, the company issues shares of common stock, which then trade on the open market. Each share represents a fraction of ownership in the company and gives the buyer a claim on the company profits — distributed in the form of dividends — as well as a vote in elections for the board of directors and maybe on other matters, depending on the company.
Raising Money for Growth
In its comprehensive “Roadmap for an IPO,” accounting firm PricewaterhouseCoopers lists many reasons for going public. At the very top of that list: raising money for growth. Privately owned businesses that want to grow often find themselves in a catch-22: To expand operations, they need more money — to acquire property and equipment, for example, and to pay new hires. But they can't generate more money from their operations unless they expand. Business loans are one option, but that money has to be paid back — often within a relatively short period, and mostly with interest. Private investors may insist on having input on day-to-day decisions. When a company sells shares of stock, however, the money it raises doesn't necessarily have to be paid back, and shareholders generally don't expect to manage the firm.
Obtaining Alternative "Currency"
When a company has stock available, it can use it as a form of currency. As noted by WealthFront, it can acquire other companies and pay for them partially or entirely with stock rather than cash. It can provide stock grants or stock options to employees and others to aid in recruiting and retention, provide performance incentives or build relationships. It can offer shares of company stock to employees as part of a retirement savings plan such as a 401(k).
Creating a Cash-Out Option
By issuing publicly traded stock, a company gives its founders, leaders, early employees and private investors a way to convert their hard work, sacrifice and risk into money. If someone owns, say, 5 percent of a privately held company, there's really no way to "cash out" short of having the company buy out her interest — something the company might not have the cash to do, even if it wanted to. But once the company stock starts trading, she'll own tradeable shares and can sell them.
The Myth of the "Pop"
Media reports tend to paint an IPO as a success if the stock has a big "pop" — a surge in value after the shares start trading. A rising price is generally a good thing, since it shows an investor confidence in the company and rewards those who took a chance on the new stock. But too big of a pop is a sign of a missed opportunity. Say a company sells stock in an IPO at $20 a share, and the price soon soars to $45. That's great for the people who bought the IPO shares — they make $25 in profit per share. But it's bad for the company, which left $25 per share "on the table" for someone else to scoop up. That's why careful pricing of an IPO is critical to ensure that a company raises as much money as possible.
With over 20 years of professional writing and editing experience, Cam Merritt specializes in writing about business and personal finance, health care and tax law. He previously worked at publications including The Boston Globe, The Des Moines Register and USA Today.
All content provided herein is for educational purposes only. It is provided “as is” and neither the author nor Office Depot, Inc. warrant the accuracy of the information provided, nor do they assume any responsibility for errors, omissions or contrary interpretation of the subject matter herein.
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