2-04 Public versus Private Companies & IPOs versus Secondary Market Securities
Now that you know what an exchange is, it’s necessary to make a very important distinction between what shares trade on exchanges and what shares don’t.
Most companies are private companies and don’t trade on exchanges. The barber shop and the florist on the corner, the guy that cuts your grass, and the plumber that fixes your sink are all likely small companies that are owned by the founder.
As companies grow, they typically find they need additional money to expand. This extra cash can come from company profits, the founder’s personal funds, borrowing (think debt and bonds here), or giving away part of their ownership (think equity here). Selling ownership to a few friends and family would be considered a “private offering” where just a dozen or so people buy ownership, but selling ownership to hundreds or thousands of investors is what is referred to as a “public offering”.
When a company decides to “go public”, they enlist an investment banking or brokerage firm to sell their shares to the public. You may have heard the term “IPO”. IPO stands for Initial Public Offering. This represents the FIRST opportunity for the public to purchase shares in a particular company. Until a company’s IPO date, they have been functioning as a privately held entity. One or a few people owned all of their stock and they were not registered or approved by the SEC (Securities Exchange Commission).
As a potential investor, you should understand a bit about the IPO process from its beginning. The IPO doesn’t happen on a whim. At a bare minimum, it involves the following.
- Compiling an impressive “track record” in business, displaying good profits and future income trends.
- Carefully considering the following:
- Market for the stock (Would people be interested in buying shares?)
- Ramifications of giving up large chunks of ownership to others
- The potential benefits (How much money could it raise?)
- The high cost of lengthy IPO preparation (There is a ton of paperwork required.)
- How the new money could help grow the company
- Assembling a team of accountants, attorneys, and advisors who are experienced in IPOs and SEC registration and approval.
- Being financially stable enough to afford the time (the process is time consuming and time sensitive) and the large expense of assembling all the SEC-required paperwork (which is massive and detailed), which is necessary to obtain approvals and permissions for an IPO.
- Locating a securities dealer or investment bank willing to sponsor your IPO to the investment market. These entities are the underwriters of your first public sale of stock.
As an investor, you should be aware that you are typically taking more risk when dealing with an IPO than with other stock purchases. Since the company has never had publicly traded stock, you have little assurance that their IPO price will stabilize or increase. However, sometimes you encounter an IPO like Google (GOOG) and your newly acquired stock may double, triple or even quadruple in a short period!
When you buy shares of an IPO, your money goes directly to the firm that you are investing in and they use it for their expansion plans. After you have bought shares in an IPO and you want to sell your shares, you must sell them on the secondary market, like the NYSE, AMEX, or NASDAQ. These shares that trade on exchanges are owned by individuals and other businesses and are sold to other individuals and businesses. When a stock trades on one of the exchanges, no more cash goes back to the company. This is in contrast to an IPO, where the seller is the company marketing their own stock and the company gets the cash from the sale of their stock. The secondary market is the major purveyor of securities around the world.
Don’t think that just because you have a brokerage account at Etrade or Schwab that you will be able to participate in an IPO. The investment banks typically sell those initial shares to other banks, brokerage firms, and high net-worth individuals. When Google went public, Etrade was given the right from Google to sell a certain number of shares, and you had to enter a lottery with Etrade to win the right to buy 100 shares of Google. I didn’t win the Etrade lottery for the Google IPO but one of our employees did. He bought 100 shares at $85 and sold it within 30 days at $125. He made a great 50% in 30 days, but within a year the stock hit $299 for a staggering 252% gain.