IPO Explained: Advantages and Disadvantages

understanding IPO 1
.14 Sep 2023
author avatar image Chad Smith

Table of Contents

In a world where the financial markets represent a vital hub of economic activity, the process of a private company offering its shares to the public for the first time – known as an Initial Public Offering (IPO) – is both crucial and complex. It’s a significant strategic decision that requires a thorough understanding of the advantages and disadvantages, the intricacies of the process, and the potential impact on the future of the company. This paper aims to provide a comprehensive perspective on IPOs, exploring not just the process, but also examining the potential benefits, drawbacks, and the essential factors to consider before stepping into the public market arena.

Understanding Initial Public Offering (IPO)

Understanding Initial Public Offering (IPO)

An Initial Public Offering (IPO) is the first sale of stock by a company to the public. Previously being privately-held, the company transitions to the public sector, hence, going public. This progression can take several months and involves various parties, including financial advisers, underwriters, and legal professionals.

The fundamental process of an IPO is complex. It starts with an internal review by the company which leads to the decision to go public. This is followed by gathering a team of experts, including underwriters, which are usually investment banks. These underwriters are vital as they assess the value of the company, the number of shares to be issued, and the appropriate offering price.

Afterwards, they produce a prospectus which is a comprehensive legal document detailing important information about the company. The prospectus is then submitted to the regulating authorities for review. In the UK, this is the Financial Conduct Authority (FCA). Once approved, the shares can be marketed to potential investors and finally, the shares are traded publicly on a stock exchange.

Why Companies Go Public

The decision to go public is often driven by a company’s need for capital. With the raised funds from the IPO, the company can finance its operations, pay off debts, funds research and development, or facilitate growth and expansion. Other reasons could be to increase the company’s market visibility, improve its market share, or to allow original investors and early employees to cash out some of their holdings in a liquid market.

Regulations Surrounding IPOs

IPOs are regulated to protect investors. In the UK, companies are required to produce a prospectus approved by the Financial Conduct Authority (FCA) detailing all pertinent information about the company. This may include financial performance, reasons for the IPO, use of capital raised, and any potential risks. A company must also comply with the regulations of the exchange on which their shares are to be listed.

Advantages of IPOs

IPOs come with several advantages. A major benefit is the significant influx of capital. This can fuel expansion, fund research or pay off existing debts. Additionally, once a company is publicly listed, it has the ability to issue more shares in the future in a secondary offering to raise more capital. Being publicly traded can also heighten a company’s public profile thereby increasing its market share.

Drawbacks of Initial Public Offerings (IPOs)

While an Initial Public Offering (IPO) may signify a notable point in a company’s journey, it’s pertinent to note that such a process is not without its inconveniences. Embarking on an IPO can be both costly and time-consuming, necessitating not only underwriting fees but also legal and marketing expenditures. Furthermore, once a company transitions to the public sphere, it’s obligated to comply with stringent guidelines and regulations. This culminates in the necessity for high levels of transparency within the company’s operations, which can prove taxing for the management team. Additionally, going public unveils a company’s financial and operational details, inviting scrutiny from both the general public and its competitors.

Illustration showing the process of an Initial Public Offering (IPO) from a company going private to becoming publicly traded.

Advantages of IPO

Benefit of Initial Public Offerings (IPOs)

Notwithstanding the challenges highlighted, initiating an IPO carries numerous advantages from which companies and investors can derive substantial value in achieving their financial aspirations. The primary benefit of an IPO lies in its ability to augment a company’s capital. By selling shares to the general public, businesses register an inflow of funds that can be earmarked for various endeavours such as market expansion, investment in research and development, debt repayment, or even acquiring other enterprises. This capital-intensive strategy allows companies to circumvent loans and the associated interest payments.

Another pivotal advantage rests in the enhancement of the company’s public image. With an IPO often comes increased credibility and visibility. Landing in the public market often thrusts the company into the media spotlight, boosting brand recognition and projecting a higher public profile. This resultant awareness can aid in attracting new business and skilled workforce while fostering advantageous alliances.

Moreover, IPOs create a platform for potential growth. Harnessing new capital resources, a company is furnished with the tools to drive rapid growth. Should the company’s value increase, shareholders stand to gain through elevated stock prices and dividends.

On the investment front, an IPO provides a prime opportunity to realise substantial profit. Investing in the early stages of a company could yield returns significantly higher than the initial investment if the company performs well. In addition, IPOs create opportunities for investment portfolio diversification, spreading risk across a wide array of assets.

Detrimental Aspects of Initial Public Offerings (IPOs)

Initial Public Offerings (IPOs), although lucrative, come with several disadvantages. A significant concern for organisations is the potential loss of command they experience post-IPO. Being publicly listed necessitates that firms are accountable to their shareholders. This includes regularly updating them about the businesses’ financial standing, future strategies, and other confidential data. This mandate can result in disagreements if the management’s plans do not coincide with shareholder interests.

Additionally, the IPO process can be costly and time-consuming. Firms are required to secure the services of investment banks, accounting firms, legal specialists, and various other professionals to ensure a proper and legal process progression. As a result of this, companies become subject to extensive regulatory scrutiny and must adhere to strict reporting guidelines and transparency regulations as mandated by authorities such as the U.S. Securities and Exchange Commission (SEC).

From the investors’ perspective, the main drawback of IPOs is the potential for a high degree of risk. When investing in a newly public company, the risk element is pronounced due to the lack of demonstrated market sustainability. The dearth of past operational data can make predicting a company’s future performance challenging. Furthermore, the post-IPO period can be marked by a high level of stock price volatility, potentially leading to substantial losses.

It is crucial for companies contemplating going public and investors considering buying into an IPO to be mindful of the characteristics of an IPO process. This includes keen awareness of both the advantages and disadvantages, leading to well-informed decisions.

Image illustrating the advantages of Initial Public Offerings, such as increased capital, enhanced public image, growth potential, and opportunities for investors.

Disadvantages of IPO

IPO Disadvantages: Questioning the Cost-Effectiveness

The question of cost-effectiveness is one of the greatest hurdles related to Initial Public Offerings (IPOs). The financial obligations associated with going public are steep, encompassing fees for investment banks, legal firms, accountants, and printing outfits. Post-IPO, firms have to bear ongoing regulatory costs including compliance expenses and increased insurance premiums. To give some perspective on costs, a study published in the Journal of Finance revealed that the mean amount incurred by a company for its IPO was approximately £7 million, without considering the underpricing costs and the cost related to lost management time.

Disadvantage of IPO: Pressure of Public Scrutiny

The transparency required by a publicly traded company means that all company’s financial and operational issues become open to public scrutiny. This increased visibility could lead to additional pressure from investors, analysts, and the media. The obligation to provide quarterly and annual reports along with reacting to any changes in company’s performance can put significant pressure on the management team. Google’s IPO in 2004 illustrates this point, as they faced a backlash from investors due to lower than expected earnings in 2008, which saw their stock price plummet from $707 to $247.

Disadvantage of IPO: Disclosure Requirements

Public companies are obligated to comply with stringent regulations and to disclose certain information to the public regularly. This disclosure includes financial statements, executive compensation details, and any material changes that could affect stock value. Though this can be seen as a strategy to ensure good corporate governance, it can also lead to the exposure of sensitive information to competitors. One notable instance is the Snapchat IPO in 2017, where the company revealed detailed user numbers and engagement data, giving key insights to rival companies.

Disadvantage of IPO: Risk of Losing Control

Once a company goes public, its founders or original owners risk losing control of the company. Unlike in a privately held company where the owners are in full control of decision-making processes, in a publicly traded company, shareholders have voting rights that can influence corporate decisions. In extreme cases, they can force the management into decisions against their will or even enact a hostile takeover. The case of Versace’s IPO in 2014 serves as an example where the Versace family, who initially controlled 80% stake of the company, saw their stake diluted when they decided to go public.

Disadvantages of IPO: Cases of Underperformance

Many IPOs underperform and fail to meet the expectations of investors. For example, the infamous Facebook IPO in 2012 was seen as the largest tech IPO in history, with a peak market capitalisation of over £81 billion. However, problems emerged almost immediately after the IPO was released, with claims of selective disclosure by underwriters and many technical glitches. The stock price plunged soon after, and many early investors suffered substantial losses.

When appraising Initial Public Offerings (IPOs), the potential advantages and disadvantages must be meticulously weighed. Going public may furnish a company with the essential capital to sustain their expansion, but it can concurrently expose them to considerable pressure, public scrutiny, and the possible diminish of control.

Illustration of the disadvantages of IPO with important points highlighted.

Evaluating if IPO is the Right Choice

Comprehending IPOs

Initial Public Offering, or IPO, provides a pathway for private companies to transition into publicly traded entities. In layman terms, the company markets its shares to the public for the inaugural time. The pivot to go public via an IPO is capable of altering a business’s path, posing both opportunities and dilemmas equally. As such, this decision mandates strategic contemplation and meticulous preparation. It compels companies to scrutinise an array of factors, such as their business model, economic performance, prevailing market conditions, and future intentions.

The Advantages of an IPO

Undoubtedly, one of the greatest advantages of an IPO is the ability to raise substantial capital. The funds derived from selling shares to the public can be used for a variety of reasons such as expansion, investments, reducing debt or funding research and development. This fresh injection of cash can speed up growth significantly, allowing the company to fulfil its strategic objectives more efficiently.

The public status can also enhance the company’s market exposure and credibility, which may further attract more customers, business partners and talented workforce. It may also provide the shareholders with a liquidity event, the opportunity to sell their shares and consequently realise their investments.

Moreover, public companies have easier access to debt markets. They can issue more equity shares or convertible securities, thereby lowering their overall capital cost. They can also use their shares as a form of currency for mergers and acquisitions.

The Disadvantages of an IPO

Conversely, an IPO also presents its share of challenges. The most significant drawbacks include the costs involved and disclosure requirements. IPOs are expensive endeavours and the costs can be high particularly for smaller businesses. They encompass direct monetary costs, including underwriting and legal fees, and indirect ones, such as the time invested by the management in the process.

Furthermore, the company becomes subject to stringent regulations and reporting requirements imposed by governmental authorities such as the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority (FCA) in the United Kingdom. This enhanced transparency may expose sensitive competitive information to the public.

Another notable disadvantage is the risk of losing control. Once the shares are sold to the public, existing owners may lose their majority holding, potentially inviting unsolicited takeover attempts. Also, the interests of new shareholders have to be prioritised, and decisions cannot be made unilaterally by the founders or existing stakeholders.

In addition, market pressures can shift the company’s focus from long-term development to short-term financial performance. Public companies are required to report their earnings quarterly, often leading to short-termism and myopic decision-making.

Evaluating if IPO is the Right Choice

In order to evaluate if an IPO is the right choice, the company needs to weigh these pros and cons against its current business model, financial condition, and future plans. It would need a solid balance sheet, good management team, stable cash flow, profit-making capability and a unique selling proposition to draw public interest.

Before making the decision, it may be useful for the company to seek advice from financial advisors, lawyers, accountants and experienced industry figures. The highly bureaucratic and complex process of an IPO means that it is also crucial to prepare the organisation comprehensively – this would typically involve strengthening corporate governance, reviewing financial procedures, building a skilled management team and setting up a competent board of directors.

Once the decision to go public is made, it has to be prepared for the post-IPO challenges. It would need a solid investor relations function, robust corporate communication and public relations strategy, and strong internal controls to meet the strict regulatory requirements and public expectations.

In conclusion, while an IPO promises significant resources, it comes with great responsibilities and should only be taken after serious consideration and adequate preparation. The decision largely depends on the company’s ability to leverage the benefits while bearing the cost and managing the risks involved.

Image depicting the process and considerations of undergoing an IPO.

Whether to go public or not is a significant decision that company must carefully ponder. With the potential to raise capital, boost the company’s image, and provide opportunities for growth, an IPO presents alluring prospects. However, these advantages are counterbalanced by drawbacks such as the cost, public pressure, and potential loss of control. Therefore, it’s essential to consider the specific circumstances, financial condition, and future plans of the business before boldly embarking on an IPO endeavour. Furthermore, it’s vital to prepare for and manage the unique set of challenges that emerge post-IPO. Ultimately, a clear understanding of IPOs and their implications can guide a company toward making a decision that aligns with its long-term growth and success.

author avatar image
Chad Smith

Chad Smith is the Director of Research & Analysis here at ForexBrokerListing.com. Chad previously served as an Editor for a number of websites related to finance and trading, where he authored a significant number of published articles about trading and the impact of technology in transforming investing as we know it. Overall, Chad is an active fintech and crypto industry researcher with more than 15 years of trading experience, and you can find him teaching his dog how to trade in his free time.