IPO Mechanics: How Initial Public Offerings Work
An initial public offering (IPO) is the first sale of a company's shares to the public. In 2021, a record 2,388 companies went public globally, raising $608 billion. The largest IPO in history is Saudi Aramco ($29.4 billion in 2019), followed by Alibaba ($25 billion in 2014).
The IPO process begins months before the actual offering. The company selects investment banks as underwriters (typically 2 to 6 banks, with a "lead left" bookrunner managing the process). The company files a registration statement (Form S-1) with the SEC, which includes detailed financials, risk factors, business description, and the proposed price range. The SEC reviews the filing and provides comments. The company and underwriters then conduct a "roadshow" — a multi-city tour where management presents to institutional investors. During the roadshow, the underwriter builds a "book" of investor orders, gauging demand and determining the final price.
Pricing is the most delicate step. The company wants a high price to raise maximum capital; the underwriters want a price low enough to ensure a successful offering and minimize their risk. The typical IPO is "underpriced" — the first-day closing price averages 15% to 20% above the offering price. This "IPO pop" represents money left on the table by the company. The average first-day return has declined in recent years as companies and underwriters have become more sophisticated. Direct listings (like Spotify and Slack) and SPAC mergers have emerged as alternatives that avoid traditional IPO underpricing.
Real-world example: DoorDash's IPO in December 2020 illustrates the mechanics. The company filed with the SEC, initially targeting a $90 to $95 price range. Strong investor demand during the roadshow pushed the price to $102. On the first day of trading (December 9, 2020), the stock opened at $182 and closed at $189 — an 85% first-day gain. DoorDash "left on the table" approximately $1.3 billion in potential proceeds that went to IPO investors rather than the company. The stock then fell 50% over the following year as pandemic euphoria faded and the market reassessed the company's growth prospects. The IPO raised $3.4 billion for DoorDash, but investors who bought at the open on day one suffered significant losses.
Post-IPO Mechanics
After the IPO, several mechanisms continue to affect the stock. The "greenshoe" (over-allotment) option allows underwriters to issue up to 15% additional shares for 30 days to stabilize the price if it falls below the IPO price. If the stock trades below the IPO price, the underwriter can buy shares in the open market (using the greenshoe allocation) to support the price — this is the only legal form of price manipulation in securities markets. The "lockup period" (typically 90 to 180 days) prohibits insiders and pre-IPO investors from selling their shares. When the lockup expires, a flood of supply can hit the market, often causing the stock to fall — Facebook fell 15% when its lockup expired in late 2012. The underwriter's "research coverage" begins after the IPO, with analysts publishing initiation reports that can significantly affect the stock.
FAQs
Should I buy IPOs?
Historically, IPOs are attractive investments only for those who get allocation at the offering price. For investors buying on the first day of trading, the average long-term return is poor — a study by Jay Ritter found that the average IPO underperforms the market by 3% to 5% per year over the subsequent 5 years. The first-day pop lures retail investors into buying at elevated prices. Most IPOs over the following 3 years trade below their first-day closing price. If you want IPO exposure, wait 6 to 12 months for the price to stabilize after the lockup expiry, or invest in an IPO-focused ETF like the First Trust US Equity Opportunities ETF (FPX).
What is the difference between an IPO and a direct listing?
In an IPO, the company hires underwriters to sell new shares to investors. Underwriters set the price, buy the shares, and resell them. In a direct listing (DL), the company lists existing shares on an exchange without selling new shares and without underwriters. There is no new capital raised — the company simply provides liquidity for existing shareholders to sell. Direct listings avoid IPO underpricing and underwriting fees but lack the capital infusion and price stabilization of an IPO. Spotify (2018), Slack (2019), and Coinbase (2021) used direct listings. The SEC approved a "primary direct listing" in 2020 that allows companies to raise new capital alongside the direct listing.
How are IPOs taxed?
IPO transactions themselves are not taxable — they are capital-raising events. However, the subsequent sale of IPO shares is a taxable event. If you receive an IPO allocation at the offering price and sell on the first day, the profit is a short-term capital gain (taxed as ordinary income). If you hold for more than a year, it qualifies as long-term capital gain (preferred rate). For employees holding pre-IPO shares, the tax treatment depends on the type of equity (ISOs, NSOs, or RSUs) and when they exercise/sell. The "lockup period" does not affect tax treatment — you can sell when the lockup expires and you will owe capital gains tax based on your basis and the sale price.