How IPOs Work

An initial public offering — an IPO — is the process by which a private company sells shares to public investors for the first time. It's how names like Google, Facebook, and Airbnb went from private startups to publicly traded companies. IPOs are one of the most-watched events in financial markets, but the mechanics behind them are often poorly understood. Here's what actually happens, step by step, and what the historical data tells us about IPO performance.

Why companies go public

Private companies pursue IPOs for several reasons. The most obvious is raising capital — selling shares generates cash that can be used to fund growth, pay down debt, or invest in new products. But an IPO also creates liquidity for existing shareholders. Founders, employees with stock options, and early venture capital investors may have held illiquid equity for years or even decades. A public listing gives them a way to sell.

Going public also raises a company's profile. Public companies benefit from increased credibility with customers, partners, and potential employees. There's a signaling effect: the scrutiny of public markets and SEC disclosure requirements suggests a level of institutional maturity that private companies don't face.

The tradeoffs are significant, though. Public companies must file quarterly and annual reports, disclose executive compensation, and subject themselves to activist investors, short sellers, and the relentless pressure of quarterly earnings expectations. Many companies delay going public as long as possible for precisely these reasons.

The IPO process

The path to an IPO typically begins six to twelve months before the first share trades publicly. The company selects one or more investment banks to serve as underwriters — firms like Goldman Sachs, Morgan Stanley, or J.P. Morgan that will structure the offering, set the price range, and find buyers for the shares. The lead underwriter, known as the "bookrunner," manages the process.

The company then files a registration statement with the Securities and Exchange Commission, most commonly an S-1 form. The S-1 is an exhaustive document that includes financial statements, risk factors, a description of the business, details of management compensation, and how the company plans to use the proceeds. The SEC reviews this filing and may request revisions before declaring it "effective" — meaning the company is cleared to sell shares.

While the SEC review is underway, the company and its underwriters conduct a "roadshow" — a series of presentations to institutional investors, typically lasting one to two weeks. The roadshow serves two purposes: generating interest in the stock and helping the underwriters gauge demand at various price levels. Based on this feedback, the underwriters set a final offering price the night before trading begins.

Pricing is as much art as science. Underwriters generally prefer to set the price low enough to ensure strong first-day demand — a visible "pop" on the opening day creates positive press coverage and satisfied initial buyers. But pricing too low means the company leaves money on the table. If a stock is priced at $20 and opens at $35, the company effectively gave away $15 per share of value that went to the institutional investors who received allocations.

The first day of trading

On the morning of the IPO, shares are allocated to institutional investors at the offering price. When the market opens — or, more typically, about an hour or two after the opening bell once the exchange specialist has matched enough buy and sell orders — the stock begins trading publicly. The first traded price is often significantly above the offering price.

Research from Jay Ritter, a professor at the University of Florida who has studied IPO data extensively, shows that the average first-day return for U.S. IPOs has historically been around 18% to 20%. In hot markets, this "pop" can be much larger. During the dot-com era of 1999-2000, average first-day returns exceeded 65%. Individual cases were even more extreme: shares of VA Linux opened at $30 and closed their first day at $239.25, a 698% gain — still the largest first-day IPO return in U.S. history.

It's worth noting that most individual investors don't receive shares at the offering price. IPO allocations go overwhelmingly to institutional investors — hedge funds, mutual funds, pension funds — that have relationships with the underwriting banks. Retail investors typically buy at the already-elevated market price once shares begin trading, which fundamentally changes the risk-reward profile of participating in an IPO.

The lock-up period

After an IPO, insiders — founders, executives, employees, and pre-IPO investors — are generally prohibited from selling their shares for a defined period, typically 90 to 180 days. This is the lock-up period, and it's designed to prevent a flood of insider selling immediately after the listing.

The lock-up expiration is a significant event because it substantially increases the supply of tradeable shares. If insiders hold 70% of outstanding shares and the lock-up period ends, the freely tradeable float can triple or quadruple overnight. Research has consistently shown that stocks tend to decline modestly — roughly 1% to 3% on average — in the days surrounding lock-up expirations, with larger declines for companies with weaker post-IPO performance or higher levels of insider ownership.

Sophisticated investors track lock-up expiration dates as potential entry or exit points. The calendar is publicly available — lock-up terms are disclosed in the S-1 filing — and institutional trading desks often position around these dates.

Long-term IPO performance

One of the most well-documented patterns in finance is that IPOs tend to underperform the broader market over the first three to five years after listing. Ritter's data, covering thousands of U.S. IPOs from the 1980s onward, shows that IPOs have historically trailed the performance of comparable public companies by a meaningful margin in the years following their debut.

The reasons are structural. Companies tend to go public during periods of peak enthusiasm for their sector — they time the window when investor appetite is highest, which often coincides with elevated valuations. The information asymmetry is substantial: company insiders know far more about the business than public investors, and the incentive structure of the IPO process favors presenting the most optimistic possible narrative. Underwriters, too, face a conflict — they earn fees from completed offerings, not from accurately pricing risk.

This doesn't mean every IPO is a poor investment. Companies like Amazon, which went public in 1997 at $18 per share (split-adjusted), or Google, which listed in 2004 at $85, have generated extraordinary long-term returns. But these are the visible survivors. The full distribution of IPO outcomes includes a long tail of companies that peaked near their listing and declined from there.

Alternatives: direct listings and SPACs

In recent years, two alternatives to the traditional IPO have gained attention. A direct listing allows a company to list its shares on an exchange without raising new capital or using underwriters. Existing shareholders can sell directly to the public. Spotify pioneered this approach in 2018, followed by Slack in 2019 and Coinbase in 2021. Direct listings avoid underwriter fees (typically 3.5% to 7% of proceeds) and the deliberate underpricing that benefits institutional allocations, but they also mean the company doesn't raise any new money in the process.

SPACs — Special Purpose Acquisition Companies — took a different approach. A SPAC is a blank-check company that goes public first, raising cash with no business operations, and then merges with a private company to take it public. SPACs boomed in 2020 and 2021, raising over $160 billion in those two years combined. The appeal for target companies was speed (a SPAC merger can close in weeks rather than months) and the ability to present forward-looking financial projections, which traditional IPO rules restrict.

The SPAC wave receded sharply after 2021. Many SPAC-merged companies traded well below their $10 initial trust value, and SEC enforcement actions targeted several for misleading projections. Research from academic studies covering the 2019-2021 SPAC cohort found that the median SPAC significantly underperformed the broader market within a year of completing its merger.

What this means for investors

IPOs are often presented as exclusive opportunities — chances to "get in early" on the next transformational company. The reality is more nuanced. The first-day pop usually benefits institutional investors who received allocations, not retail buyers who purchase at the open. The lock-up expiration creates a supply overhang that can depress prices. And the long-term data suggests that patience — waiting for a newly public company to establish a track record and for the initial hype to subside — has historically been a more reliable approach than chasing the opening-day excitement.

Understanding the process doesn't require avoiding IPOs entirely. It simply means recognizing that the mechanics of going public are designed to serve the company and its underwriters first, and that the asymmetry of information between insiders and public investors is at its greatest on the day a company first starts trading.

Picksmith provides information, analysis, opinions, and tools for general informational and educational purposes only. Nothing on Picksmith should be considered investment, financial, legal, tax, or other professional advice. Past performance is not indicative of future results.