An IPO – initial public offering – is the process whereby a private corporation “goes public” by offering stock to public investors. IPOs offer private companies a chance to raise new capital, while public investors have an opportunity to jump aboard the train at the first station.
A DPO – direct public offering – lets companies skip intermediaries, bypass restrictions from banks and venture capitalists, and offer securities directly to the public. DPOs provide private investors a chance to sell their shares in the broader market, while companies can still benefit from such crowdfunding efforts
Typically, the average investor may benefit more from waiting until a few months after a company’s IPO (when the hubbub has presumably died down and shares cost less) to purchase stock
When you first start investing, it’s easy to get caught up in the exciting world of stocks, bonds, and other assets suddenly at your feet. But in the midst of the ensuing exploration and debate – should I invest in Amazon or Shopify? Pfizer or Moderna? – have you ever stopped to wonder why there are some companies you can’t buy?
Any corporation available on an exchange is a public company, which broadly means that the general public can trade their stock. On the other hand, private companies are held by insiders – founders, employees, family and friends, and early investors. So how does a company go about becoming public and listing on an exchange?
The answer is with a public offering.
What is an IPO?
An IPO, or initial public offering, is the process whereby a private company offers stock to the public at large. Before their IPO, a company is still considered private, and funds flow in from a relatively small pool of investors. As a private entity, companies often focus on defining their mission, building name recognition, and growing their customer base.
But when a company reaches the stage where founders believe it can adhere to SEC regulations, as well as the expectations of and legal obligations to public shareholders, it can file its intentions to go public.
The IPO Process
Filing for an IPO signals significant changes ahead, and it’s not a short process by any means. While there are tons of nuances to navigate, there are five major milestones that every hopeful entity must hit for a successful IPO.
1. Underwriting the Offering
Underwriting typically occurs six or more months before the IPO itself. The underwriter is crucial to an IPO’s success, as it’s their job to ensure that shares are sold at the set price.
The process kicks off after the issuing company announces its intention to go public. At this point, banks and other institutions can submit bids to handle the proceedings. These bids detail fees (up to 7% of the IPO total sales) and how much the IPO will raise.
Then, the company can select the best applicant based on price, reputation, and expertise. Typically, the issuing entity looks for a bank that will drum up the most business, as it’s the bank’s responsibility to gather initial buyers.
Once the company selects a bank, the two institutions enter an agreement that outlines important details, such as:
- How much money will be raised
- The type(s) of securities issued
- Underwriting fees
2. Regulatory Filings
This process occurs at least three months before the IPO. During this time, an IPO team consisting of the lead investment banker, lawyers, accountants, SEC experts, and others assembles to hash out the details of the IPO. Typical considerations under this team’s purview include:
- Assembling financial information
- Noting potential areas of improvement
- Writing off unprofitable assets
- Seeking new executives and Board of Directors
Once the appropriate arrangements have been made, the IPO team files an S-1 registration statement with the SEC detailing information about the company and upcoming offering. It also details how the initial funds will be used, among myriad other details.
3. Approval and Pricing
At this point, the SEC will investigate the company to ensure that all its ducks are in a row. If the issuing institution passes muster, the next step for the IPO team is to set a date and price the new company.
To do so, the underwriter puts together a prospectus of the hopeful company to circulate among prospective buyers. The company’s top executives can then present this data to institutions to drum up business – this is known as the “road show.” During this time, investors can submit bids for how many shares they would like to buy. The underwriter then takes investor interest into consideration when determining a prime IPO price.
In the months before the IPO, the new Board of Directors will meet to review an audit of the company’s current situation. The company will also file with its intended stock exchange(s) to list its IPO. However, bidding investors don’t learn how many shares they can buy until the day before the IPO.
This step occurs immediately after the IPO, but it’s still an important one. In the days following initial trading, the underwriter will ensure a continuing market for the stock. The goal is to keep interest high enough that the stock doesn’t fluctuate too wildly. This “quiet period” only lasts for 25 days and serves as the hand-off to the last phase of the IPO process.
25 days after the company’s IPO, the quiet period ends. The underwriter is then tasked with providing estimates about earnings, which helps investors “transition” to relying on mandated public information about the company.
What is a DPO?
On the other side of the public-capital-raising spectrum, we have a DPO.
Also known as a direct public offering or direct placement, this is where a company offers existing securities directly to the public. In self-underwriting its stock, a company removes intermediaries such as the underwriter, SEC experts, and other legal and regulatory individuals.
Typically, companies that offer DPOs are not seeking to procure the same level of capital investment as those who offer an IPO. One common reason to issue a DPO is to allow invested employees the chance to trade their shares to an outside market, thereby providing them with liquidity. Companies may also appreciate the opportunity to raise capital from their community while broadening their horizons beyond institutional investors.
DPOs are often attractive to smaller organizations that want to go public without paying millions to an underwriter. They can also bypass restrictions imposed by banks, capitalists, and other financiers. As a result of this decision, the company is responsible for setting their terms and tailoring the process to its best interests.
The DPO Process
Preparing a DPO can take weeks to months, depending on the organization. In a DPO, the company can decide what types of investments it wants to offer, then issue a memorandum detailing the issuer’s background and potential offerings. Then, it’s up to the company to decide how to market their securities – be it via printed, digital, or social media ads, public meetings, or other methods.
Before officially offering shares, the company must also file compliance documents according to relevant Blue Sky Laws in any state wherein it intends to offer a DPO. These documents outline financial data, memorandums, and other official paperwork. However, most companies that issue a DPO do not need to register with the SEC if they qualify for federal security exemptions.
Upon receiving regulatory approval, the company can officially announce its direct listing. Instead of issuing new stock, the company’s owners and investors convert their ownership into shares of stock or other assets. These securities are then offered to any investors who want to purchase ownership in the company, either by listing the securities on an exchange like the NYSE or selling them on OTC (over-the-counter) marketplaces.
IPO vs DPO: Which is Better – and for Whom?
Both IPOs and DPOs have benefits and drawbacks for the issuing companies and their future investors. While some companies do better with one model over the other, the founders must consider their options carefully to reap the most benefits for the lowest risk.
IPOs: The Pros and Cons
From the company’s view, IPOs are popular because they provide a chance to raise capital quickly. This increased budget gives a company room to expand, invest in infrastructure, or hire new employees. Increased transparency due to SEC rules also makes companies more attractive to prospective lenders.
On the other hand, IPOs are a lot of work for a growing company – not to mention expensive. 3-7% of a total IPO can total hundreds of millions of dollars. Furthermore, the current owners may not be able to take shares for themselves. (Even if they do, the lockout period prevents them from selling shares within six months.)
An IPO is also a chance for private investors to reap the reward for investing early. The company’s founders, current management, and employees have an opportunity to hop off the train early, while new investors can jump on. And investors who get in at the first stop have the potential to earn big as shares skyrocket in the early hours.
However, getting in early can come at a high cost. IPOs are not designed for long-term performance – they’re priced at a premium so founding members can cash in on their hard work. Not to mention, there are more unknown variables and a higher potential of price volatility early on, especially compared to well-established companies.
DPOs: The Pros and Cons
Direct listings are often attractive to smaller companies that want to secure public funding without the burgeoning costs associated with IPOs. While this path is riskier, it’s a great way for companies to avoid share dilution, lockout periods, and focusing on institutional investors rather than their community. Not to mention, they don’t have to bare their souls in mandated SEC filings.
Because companies might offer a DPO for different reasons than an IPO, this has unique benefits for investors. Chiefly, they provide employees, family and friends, and company founders with the chance to sell their shares to the outside world. This provides both the company and its employees with greater liquidity.
However, DPOs can be risky propositions.
For one, there is no underwriter to bolster share prices by purchasing leftover stock, which can lead to cancelled offerings. Companies may also struggle to drum up enough interest without access to a built-in pool of promoters and institutional investors. And if they do manage to turn enough heads, they won’t have a greenshoe clause to sell more shares than planned in the event of higher-than-expected turnout.
Furthermore, those investors who do show up may not have the company’s long-term interests at heart. This can leave the company without stable shareholders, thereby leading to increased volatility and unpredictable market performance.
What to Do if a Company Goes Public
Public offerings are an exciting (and busy) time for a company, and they provide investors with a chance to get in on the ground floor. But for most people itching to hop aboard, it’s best to wait a few weeks – or even months – for the hubbub to die down.
As a class, IPO securities are not designed to perform well relative to the current market. Rather, they’re priced at a premium to rake in the most capital possible. (The same may not necessarily be true of a DPO, though investors should still watch for signs of overpriced securities.)
Furthermore, many advanced investors use IPOs as a chance to speculate in the market, which can increase early volatility and drive prices into overvaluation territory. While many IPOs experience a surge in the first day or two, the bottom often drops out as interest wanes, which leads to unfortunate – and in many cases, unnecessary – losses.
But if you’ve considered your options and decided that IPO investing is for you, be sure to evaluate the company from multiple angles. Consider:
- Whether the company has a significant competitive edge, such as unique patents or trademarks, or particularly effective executives
- If there’s a current or growing market for their goods or services
- Whether you’d be comfortable purchasing the stock knowing that its shares could fall for a time
- If you agree with the company’s mission and business plan
But most importantly, you want to make sure that the business is foundationally and fundamentally strong. Otherwise, you’re setting yourself up for future disappointments – not to mention losses.