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Initial Public Offerings

Taking it Public

Having enough choices isn't usually a problem when you invest. You can buy stock in one of the 5,000 companies - give or take a few dozen - listed on the New York Stock Exchange (NYSE) or the NASDAQ in the United States or in roughly 10,000 stocks available over-the-counter (OTC) on either the OTC Bulletin Board or the Pink Sheets. They're all publicly traded. To be publicly traded, the company has to "go public." That means that it requires an initial public offering, or IPO, that makes its shares available to outside investors for the first time. Fun fact: Less than 1% of all US companies are publicly traded.

First, the "why"

A company goes public to raise money - hopefully lots of it - by selling part of itself to investors.

Doing an IPO means the company's owners give up some control over who sits on its board of directors and over some decisions that the board makes. The company also has to be responsive to investors' demand for profits. But on the plus side, the money the IPO brings in never has to be repaid the way a bank loan or a bond does.

What's the money for? A company may go through an IPO to raise cash for additional growth or research. It may be to expand, to take the company in a new direction, or to acquire other companies. It's also a way for the original owners and early investors to profit from the time, effort, and money that went into building their company.

Next, the "how"

Most companies take a traditional route to an IPO. They work with an investment bank that underwrites the offer. The bank advises the company on putting the IPO together and what to say in the prospectus that the Securities and Exchange Commission (SEC) requires before it will allow the offer to proceed. The underwriter also helps drum up interest.

When the day comes, the bank, in consultation with the company, sets the size of the offering - that's the number of shares - and an initial price per share. In some cases it even buys up the whole lot, which can be a key part of the deal.

The IPO goes live when the investment bank sells the shares at the set price to a select group of investors that were chosen to participate in the initial offering. When the shares begin to trade in the secondary market, that initial launch price goes up or down to reflect public demand (just like any other stock). But unless the company has a big name, and the IPO gets a big buzz, it can be tough to find buyers.

Is an IPO right for you?

Your first chance to buy shares of a stock in an IPO is usually when it starts trading in the secondary market, which isn't actually part of the IPO. But is jumping on the new stock bandwagon smart? Some IPOs do take off. In fact, the price may soar quickly. That's one reason that many brokers require a limit order if you're trying to score some of those new shares in the secondary market. The price can be higher - sometimes much higher - than the IPO price once the stock starts trading.

The real question is, will the interest in the stock last? It's not unusual for the recently-IPO'd shares' price to settle close to the issue price over the first few weeks the stock trades. A lot of new issues have traded at lower prices than comparable companies - sometimes for years.

There's no way to be sure. But here's a test: if the new stock would help diversify your portfolio, the price is right for you, and the independent research you can find is positive, it might be time to think seriously about buying. Check out the IPO Center to see what's hitting the market soon.

The difference between Primary and Secondary markets

One thing that's surprising to investors is just how hard it can be to get in on that initial pricing. In order to participate in the initial offering of a stock, you have to be a customer - often a longtime, high-value customer - of one of the brokers that is part of the selling group. The vast majority of folks just have to wait until that stock begins trading on the secondary market.

The secondary market isn't as grey as it sounds - all it means is that the stock is trading on an exchange, like the NYSE or the NASDAQ. The biggest difference between buying shares of an IPO in the primary versus the secondary markets is that unlike those initial investors, you're never guaranteed a price.

That's why it's always a good idea to decide - before you buy - just how much that stock is worth to you. When a new issue is the most talked-about thing in town, it can be in high demand, which also means its price can be high. If there are a bunch of people in line to buy up shares on the secondary market, that price can jump to a place that you think is just not worth it. That's why it's a good idea to place a limit order if you're trying to get in early. Decide how much you are willing to spend, and stick with it.