How an IPO Works
IPO is one of the few market acronyms that almost everyone is familiar with. The term conjures up pictures of sudden millionaires watching in glee as their previously inert holdings are translated into actionable money. If you’ve taken even a cursory look at the business news over the past few months, you’re probably aware that Facebook is moments away from its initial public offering. Today, you can’t buy Facebook stock because there’s no publicly available stock to buy. One morning, however, that will change; the trading floor will open, Facebook’s symbol will scroll across the ticker and its stock will be available to whomever wants it – kind of.
Before an IPO, a company is privately owned – usually by its founders and maybe the family members who lent them money to get up and running. In some cases, a few long-time employees might have some equity in the company, assuming it hasn’t been around for decades. The founders give the lenders and employees a piece of the action in lieu of cash. Why? Because the founders know that if the company falters, giving away part of the company won’t cost them anything. If the company succeeds, and eventually goes public, theoretically everyone should win: a stock that was worth nothing the day before the IPO will now be worth some positive number of money.
However, because their shares don’t trade on an open market, those private owners’ stakes in the company are hard to value. Take an established company like IBM; anyone who owns a share knows exactly what it’s worth with a quick look at the financial pages. A privately held company’s value is largely a guess, dependent on its income, assets, revenue, growth, etc. While those are certainly much of the same criteria that go into valuing a public company, a soon-to-be-IPOed company doesn’t have any feedback in the form of a buyer willing to immediately purchase its shares at a particular price.
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