Initial Public Offering (IPO) Explained

An Initial Public Offering (IPO) is when a private company first sells shares to public investors, transitioning from private ownership to public trading on a stock exchange. It's the traditional path to becoming a publicly traded company, the primary way new companies enter the investable universe, and one of the most consequential events in any company's evolution.

What it measures

The IPO process typically involves:

Pre-IPO preparation (12-18 months):

• Investment bank selection (underwriters)
• Financial audits and SEC registration
• Roadshow to institutional investors
• Pricing range establishment

The IPO event:

• Underwriters allocate shares to institutional investors at offering price
• Stock begins trading on first day on stock exchange
• "Greenshoe" option allows underwriters to sell additional 15% of shares
• Underwriters often stabilize price through market-making

Post-IPO period:

• 90-180 day "lockup" prevents insider selling
• Quiet period restricts management commentary
• First earnings report typically several months post-IPO
• Index inclusion eligibility (S&P 500, Russell, etc.)

A simple example: $ABNB went public in December 2020. The company:

• Set initial price range of $44-50 per share
• Raised the range to $56-60 after strong demand
• Priced IPO at $68 (above range)
• Opened trading at $146 on first day
• Closed first day at $144.71

The first-day pop of 113% was extraordinary and reflected the demand for the brand. The pattern: shares allocated at $68 to favored institutional investors, while public market buyers paid $146+ for the same shares.

How to use it in practice

The IPO market characteristics:

IPO premium: First-day gains average 18% historically, with significant variance. Hot IPOs have produced first-day gains of 200%+; cold IPOs have priced below range or been pulled.

Underpricing rationale: Several theories explain underpricing:

• Compensation to underwriters for marketing risk
• Allocation tool for relationships with institutional investors
• Risk-sharing between issuer and investors
• Asymmetric information considerations

Selection bias: Companies that complete IPOs are typically those facing favorable market conditions. Less favorable periods produce fewer IPOs.

Institutional vs retail access: Allocations primarily go to institutional investors. Retail investors typically must buy in secondary market at first-day prices.

Recent significant IPOs:

$UBER: Went public in May 2019 at $45. Initial trading was disappointing, with shares declining below offering price. Has subsequently performed reasonably as the rideshare business matured.

$ABNB: December 2020 IPO at $68. First-day pop to $146. Has traded in $90-180 range since, with current value reflecting maturing business growth.

$DASH: December 2020 IPO at $102. Strong initial trading. Has experienced significant volatility but maintained meaningful market cap.

$RBLX: March 2021 direct listing. Reference price was $45; opened at $64.50. Has traded in wide range as gaming sector volatility affected the stock.

$RIVN: November 2021 IPO at $78. Briefly traded above $172 before declining substantially as EV sector cooled and execution challenges emerged.

The IPO investment patterns:

First-day flips: Investors who receive IPO allocations often sell on first day to capture initial pop. This creates supply pressure but locks in returns.

Lockup expiration: When 90-180 day lockup expires, insider selling can pressure stocks. Many IPOs trade lower around lockup expiration.

First earnings: First public earnings report typically several months post-IPO. Can be volatile event as company adjusts to public reporting.

Index inclusion: Eligibility for major indices (S&P 500, Russell, etc.) typically requires history. Index inclusion can drive demand from passive funds.

The historical IPO performance:

Academic research on IPO performance shows mixed results:

• First-day returns: Average 18% pop. Shows demand exceeds supply at offering price.
• First-year returns: Mixed, with high variance. Some IPOs underperform broader market in first year.
• Long-term returns: Some studies suggest IPOs underperform broader market over 3-5 year periods.
• Hot vs cold markets: IPOs in hot markets often subsequently underperform; IPOs in cold markets often outperform.

The IPO concentration in cycles:

Modern IPO markets are highly cyclical:

1990s tech bubble: Massive IPO activity in tech sector. Many failed; some became dominant companies.

2020-2021 SPAC and IPO boom: Record IPO activity driven by zero rates and risk appetite. Many subsequent disappointments.

2022-2023 IPO drought: Higher rates and risk aversion dramatically reduced IPO activity.

2024-2026 recovery: Gradual recovery in IPO activity as rate environment stabilized and quality companies returned to public markets.

For investor approaches:

Avoid first-day buying: Most retail investors should avoid buying IPOs on first day at elevated prices. Wait for stabilization.

Watch lockup expiration: First lockup expiration (typically 180 days post-IPO) often creates buying opportunities as insider selling pressures price.

Wait for first earnings: First quarterly report as public company can clarify business trajectory and create entry opportunity.

Long-term focus: IPO investing is most successful for investors with multi-year horizons, not first-day traders.

Quality assessment: IPOs represent companies first being scrutinized publicly. Quality assessment is harder than for established public companies.

The IPO selection process:

Companies typically choose between IPO methods:

Traditional IPO: Most common. Underwriters handle pricing, allocation, and stabilization. Company raises capital from primary offering.

Direct listing: Existing shares listed without raising new capital. Examples: $SPOT, $COIN, $RBLX. Reduces underwriting costs but provides less capital raising.

SPAC merger: Reverse merger with publicly-traded SPAC. Was popular 2020-2021 but became unfavorable as many SPACs disappointed.

Reg A+ offering: Smaller offerings under different regulatory framework. Typically for smaller companies.

The implementation considerations:

Allocation access: Most retail investors can't access IPO allocations at offering price. Must buy in secondary market.

Brokerage IPO programs: Some brokerages (Fidelity, Schwab, Robinhood) offer IPO access to retail clients with sufficient relationship. Allocations typically small.

Caution on hyped IPOs: The most-hyped IPOs often have the worst long-term performance. Quality assessment matters.

Patience for entry: Initial post-IPO trading often includes irrational pricing. Patience for fundamental valuation typically improves outcomes.

Common mistakes

Buying IPOs on first day at peak prices. Initial trading often reflects demand-supply imbalance rather than fundamental value. Patient buyers typically get better entry points.

Treating IPO companies as established. IPO companies have limited public reporting history. The financial transparency that makes established companies analyzable doesn't yet apply.

Ignoring lockup expiration risk. Insider selling at lockup expiration can pressure prices significantly. This often creates buying opportunities but creates temporary weakness.

Concentrating in IPOs. IPO portfolios have historically underperformed broad market. Single-IPO concentration is even more risky.

ACCE perspective

IPOs aren't directly in our scoring system because newly public companies often lack the financial history needed for our percentile-based scoring. We typically wait until companies have 4-6 quarters of public reporting before adding them to our coverage universe with full scoring.

For investors building portfolios, IPOs represent one of the higher-risk segments of equity markets. The combination of limited history, high volatility, and potential demand-supply imbalances makes IPO investing more challenging than established public companies. For most retail investors, waiting until companies have established public track records and reasonable valuations produces better outcomes than chasing initial offerings.

The most reliable approach for most investors is allowing newly public companies to establish trading patterns and reporting history before evaluating them as potential investments. Quality IPOs (genuinely good businesses going public at reasonable valuations) often provide better entry points 12-24 months after offering than at the IPO itself.