Initial public offering (IPO)

An initial public offering, or IPO, is the moment when a private company first offers its stock to the public, listing on a stock exchange. IPOs are rituals of capital raising, growth, and founder enrichment, but they are also rituals of underpricing — the vast majority of IPOs rise sharply on the first day, a sign that they were sold to the public at a discount to what the market thinks they are worth.

Why go public? The strategic imperative

A private company goes public for three main reasons:

Raising capital. A private company can only raise money from private investors (accredited individuals, private equity firms, venture capitalists). To raise hundreds of millions, the company needs public markets. An IPO is a one-time massive capital raise.

Creating currency. Once public, a company’s stock has a liquid, publicly known value. That stock can be used to acquire other companies (pay with stock instead of cash) and to issue equity-based employee compensation. This flexibility is a powerful tool for growth.

Founder and investor exit. Private equity investors and early-stage venture backers have a time horizon — often 7–10 years. An IPO provides a liquidity event where they can cash out and return capital (and gains) to their own investors.

Founders often want to go public for ego and wealth reasons, but not always. Many will argue they are being forced public by their investors: the private holders want a return, and the only way to get it is through an exit event.

Bookbuilding: how the IPO price is set

Before a company is listed, the IPO price is set through a process called bookbuilding. Here is how it works:

The company hires underwriters — major investment banks like Goldman Sachs, Morgan Stanley, or JPMorgan — who handle the IPO. The underwriters prepare materials (the prospectus, financial statements, risk disclosures) and begin marketing the IPO to institutional investors: mutual funds, hedge funds, pension funds, insurance companies.

The underwriters invite these investors to bid on shares. Each investor indicates how many shares they want at various prices. The underwriters aggregate these “indications of interest” and determine a price range — say, $16–$18 per share.

Final bids are submitted, and on the eve of the first day of trading, the underwriters and company agree on the IPO price. This is typically near the middle to high end of the range, but not always — if demand is weak, it might be in the middle or even below.

Here is where the underpricing becomes apparent. Retail investors are not invited to the bookbuilding process; their access is limited and allocated sparingly. Institutions dominate. And institutions systematically underbid relative to the price they expect the stock to trade at on the first day. This benefits them: they get shares at a discount and flip them for immediate gains. The company and existing shareholders are the ones subsidizing this.

The IPO day and the first-day pop

On the first day of trading, something remarkable happens in most IPOs: the stock pops 15%, 25%, or sometimes 100% above the IPO price. A company with an IPO price of $20 might close the day at $25.

This is a massive red flag. If the stock is worth $25 on day one, why did the underwriters price it at $20? The answer is that underwriters, on behalf of institutions, intentionally underpriced the deal. A moderate pop looks good for everyone: the company got its capital raise (a bit cheaper than it might have, but that is the price of doing business), the underwriters have a “successful” IPO to brag about, and the institutional investors who got allocations have easy day-one gains.

Retail investors who buy on the first day, after the pop, are the ones who lose. They pay the higher price after the institutions have already cashed in.

The lock-up: when insiders can finally sell

For the first 6 months after an IPO, company insiders — founders, executives, early investors — are prohibited from selling their shares. This is the lock-up period. The theory is that without a lock-up, insiders would immediately dump shares on day one, flooding the market and tanking the stock.

But the lock-up creates a predictable dynamic: the day the lock-up expires, a massive volume of insider shares becomes eligible for sale. Many insiders do sell (or some do), and the stock often falls on lock-up expiration. Some IPOs have seen declines of 10–20% or more.

For a retail investor, lock-up expiration is a date to watch. If you are holding an IPO that has risen significantly, the lock-up expiration is a risk event.

First-day pops are not the whole story

A common misconception is that IPO investors who get day-one allocations make huge returns. The data tell a different story. If you average the returns of IPOs from the first day of trading to one year later, they are mediocre. Many IPOs outperform the market, but many underperform. The first-day pop is a gift to institutions; the rest of the return is no better than what you would get from buying the broader stock market.

And for companies that go public during hot markets (when investor sentiment is frothy), IPOs often underperform significantly. During the tech boom, the extreme valuations at which companies were taken public meant there was little room for return. Buying an IPO at the peak of its hype is often a poor decision.

Who benefits and who does not

Let us be clear about the wealth transfer: the IPO process benefits the underwriters (they take a 3–7% fee on proceeds, so a $1 billion IPO nets them $30–70 million), it benefits the institutions who get pre-IPO allocations and can flip them for day-one gains, it benefits founders and existing investors who are finally cashing out, and it benefits employees who now have valuable stock options.

It does not particularly benefit new retail investors who buy on day one, and it modestly disadvantages the company, which sold stock at below what the market instantly values it at. But companies are willing to accept this because they get capital and the publicity of the IPO is valuable.

Direct listings: an alternative

In recent years, some companies have chosen a direct listing instead of a traditional IPO. In a direct listing, existing shareholders (including insiders and employees) can sell shares directly to the public, without an underwriter managing a bookbuilding process.

Direct listings are simpler, cheaper, and more transparent, but they do not raise new capital for the company — existing shareholders are the ones selling. They are best suited for companies that do not need capital and are primarily interested in creating a liquid market for their shares.

After the IPO: the transition

The moment an IPO closes, everything changes. The company is now public — it must file quarterly and annual financial statements, it must disclose material information, it must hold annual shareholder meetings, it faces liability if directors or executives are negligent, and the stock price is constantly marked to market. The CEO’s equity compensation is tied to the stock price, creating pressure for short-term performance.

For some companies, the transition is seamless. For others, the pressure to deliver quarterly results conflicts with long-term strategy, and they struggle. Going public is not an unambiguous good; it is a trade-off between access to capital and loss of privacy and operational flexibility.

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