What is an IPO? Initial Public Offerings Explained

An initial public offering, or IPO, is the process through which a private company becomes a public company with publicly traded shares.

As the name suggests, an IPO signifies the first time a stock is made available on a public market through an exchange—like the New York Stock Exchange (NYSE) or Nasdaq—allowing investors to buy and sell the stock. The process of taking a company from private to public is often called "going public."

Companies go through an IPO for a variety of reasons, but two of the most common reasons are to help raise capital for future growth opportunities and to provide potential liquidity for existing shareholders.

Through an IPO, a private company can raise capital from public investors by issuing public shares of stock. The capital raised from the public offering can help a company with a variety of capital-intensive initiatives like paying down debt, hiring new employees, acquiring other companies, or expanding its operations.

Liquidity can be especially valuable for early investors and shareholders, including employees who joined the company during its early startup years and may want to sell some company stock. An IPO can potentially create liquidity by providing early investors with a path to convert previously illiquid shares into cash or more liquid public shares.

Once a company's leadership team decides to launch an IPO, there is a due diligence period where the company undergoes a financial audit looking at all aspects of the company's financials. Once the company's books are in order, the company works with several key players including investment banks (underwriters), securities attorneys, and auditors to determine key aspects of the IPO like the proposed IPO valuation, number of IPO shares to issue, expected IPO offering price range, and the IPO launch timeline.

Once a company has established their IPO strategy and has filed their S-1 document (see below), the executive team typically embarks on an IPO roadshow where they pitch the business to institutional investors, either virtually or in person, to help market their company shares and build demand for their stock.

Once the company and underwriters have established the terms of the IPO and all the necessary paperwork has been properly filed and approved, the company lists its stock on a publicly-traded exchange where public investors can trade—purchase and sell—the company stock.

An S-1 document, or Form S-1, is the official registration statement a private company (known as "the issuer") files with the U.S. Securities and Exchange Commission (SEC) before a company goes public. The lengthy document, called a prospectus, provides transparency into the company's financials and operations by providing financial statements, risk factors, equity compensation plans, the company's management structure, and how the business plans to use the capital raised from the IPO.

The S-1 document can also be a useful resource for potential investors to gauge a company's financial health, operations, and risks.

If a private company files an S-1 document, it's a strong indicator that a company intends to go public, but it's not a guarantee the company will IPO.

When a company goes public, the impact on employees varies. An IPO might not impact you at all or, in some cases, your company might offer you equity compensation.

As an employee, you might be offered an opportunity to get a stake in your company through stock options or other types of equity compensation. Or you might already own shares in your company and need to know what will happen to your stock after the IPO.  

Equity compensation, which can also be provided outside of an IPO, is offered to employees as shares of ownership in the company. It allows employees to share in the success of a company if its stock appreciates in value. Common types of equity compensation include:

Restricted stock units (RSUs) and restricted stock awards (RSAs) grant you the right to receive a set number of your company's stock shares once they vest, which is the predetermined date when you'll own the shares.

Performance stock units (PSUs) and performance stock awards (PSAs) are similar to RSUs and RSAs, granting you shares when they vest, but the number of shares fluctuates depending on the performance goals set by of your company.

Stock options give you an opportunity to buy shares at a future date for a set price. When the stock options vest, you can exercise your right to buy shares at the set price. There are two main types of stock options: Incentive stock options (ISOs) and non-qualified stock options (NQSOs).

An ESPP is a program that allows you to buy shares of your company's stock at a discounted price.

Before a company goes public, it will inform employees of trading rules and restrictions related to selling company shares owned before the IPO. You may need to wait to sell your shares during a lock-up period or adhere to other trading restrictions. Consult with your company and review grant agreements and plan packages to understand the details of your plan.

Many companies enter a lock-up period following the launch of an IPO. During that time, company insiders aren't allowed to sell their company shares. The lock-up period typically lasts between 90 to 180 days.

The lock-up period is designed to stabilize the price of shares after an IPO is launched. It prevents insiders in the company from impacting the value of the stock by flooding the stock market with their shares.

In addition to a lock-up period, you might be prevented from selling company stock during blackout periods. During blackout periods—which often occur before quarterly or annual earnings releases—some employees are prohibited from trading their company stock or exercising their stock options.

Each type of equity compensation has its own set of tax rules. Here's a general overview of how you will be taxed in the U.S. on some common types of equity compensation.

If your company grants you RSUs or PSUs, you will experience two taxable events. First, you will pay ordinary income tax when the shares are delivered to you, which is typically when they vest. Then, if you sell your shares, you will incur a capital gain or loss, depending on whether the value of the stock increased or decreased. If you had a gain, you will be subject to capital gains tax.

The IRS typically treats RSAs and PSAs as taxable ordinary income, based on the shares' value when they vest. However, RSAs and PSAs also let you use the 83(b) election to report the stock award as income in the year shares are granted rather than when they vest. This election allows you to pay all the ordinary income tax upfront, so you won't be taxed again until you sell the shares. You need to make the election within 30 days of the grant.

With ISOs, the spread (the difference between the award price and the market price) will count as taxable income when calculating the alternative minimum tax (AMT) in the year you exercise your options. If you hold the shares for more than one year past the exercise date and more than two years past the original grant date, the sale of the stock becomes a qualifying disposition, and any realized profit is typically taxed at the long-term capital gains rate. If you sell earlier, the spread will be taxed at your ordinary income tax rate.

For NQSOs the spread is taxed as ordinary income in the year in which you exercise the options—even when you hold on to the shares—and companies usually withhold some of the proceeds to help pay applicable taxes.

The tax treatment of your shares typically depends on how long you hold them before selling. For most ESPPs, the sale may be classified as either qualified (sale of shares after one year of the purchase date and after two years of the grant date) or disqualified (sale of shares within one year of the purchase date or within two years of the grant date). This classification will typically determine how much of your gains will be taxed proportionately between ordinary income and capital gains.

Note: These guidelines refer to U.S. taxation. International tax filers may have different obligations. Be sure to meet with a tax professional to discuss your specific situation.

Employees who hold company stock may face two primary risks with their shares when their company goes through an IPO: stock price volatility and share dilution.

• Stock price volatility: In the early days and weeks after an IPO, the share price can move sharply as the market reacts to new information and investor demand. That volatility can quickly change the value of the stock or equity compensation employees hold.
• Share dilution: An IPO or follow-on public offering can reduce an employee's ownership percentage if additional shares are created. Dilution can lessen both the relative value of an employee's stake and, in some cases, their voting power.