What is an IPO?

An initial public offering, or IPO, is the first sale of shares in a company to the public.

Although IPOs have been occurring for years, the term came to have a high (and notorious) profile during the soaring stock markets of the late 1990s, and in internet start-up companies.

People watched enviously as young internet entrepreneurs, such as Lastminute founders Martha Lane-Fox and Brent Hoberman, made fortunes as their fledgling companies underwent IPOs and the value of the new shares soared.

But the dotcom boom – that soon became a bust - was an aberration to the normal ‘route to market’ that companies take.

Companies are either private or public. A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Most small businesses are privately held, but some large companies are also private, such as Ikea.

It usually isn't possible to easily buy shares in a private company. Public companies, on the other hand, sell at least a portion of themselves by ‘going public’.

A company will normally decide to go public because it needs money to grow - and an IPO generates lots of money. If the company is in a strong position, with a good track record of sales and profitability it will be attractive to investment banks that underwrite (or guarantee) IPOs.

Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors, and they must report financial information.

Being publicly traded has several advantages.

Because they are governed by tight rules, public companies can usually get better rates when they issue debt.

As long as there is market demand, a public company can always issue more stock to be bought by members of the public. This helps the company grow.

There can also be disadvantages for the founders of companies when they go public.

Founders can often lose control of the firm they built, and even be removed by the board of directors.

The dotcom boom lowered the bar for companies wanting to make an IPO. Many start-ups (new businesses) went public without any profits and little more than a business plan.

Founded on money from venture capitalists (who fund companies with a hope of seeing a high return on their investment), the young companies hoped to create enough of a stir in the market to raise demand for their IPOs and relied on a soaring stock market to realise their money.

Critics felt that many venture capitalists and fledgling internet firms were only interested in the IPO, rather than creating a long-term and established business with real value.

It is very difficult for an individual investor to buy shares in an IPO. A good company (one that stands a chance of doing well in the long term) will sell shares to big institutional investors in volumes that individuals cannot match.

If you want to buy shares in a particular company, you have to wait until they start trading on the stock exchange.

IPO shares are risky. The company has no track record, and the information available on which to base your investment decisions is not as good quality as for a publicly traded company.

If you really want to buy shares in a particular company an alternative is to wait until the ‘lock-in’ period has expired. This is the time when company directors and other insiders cannot sell their shares. If the share price stays steady when the lock-in period ends that means those in the know have faith in the company.