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The IPO Process

Apr 18, 202615 min read

The IPO Process

An IPO (Initial Public Offering) is a company’s first sale of equity to public investors — the moment a private company becomes publicly traded.

This note walks through the full lifecycle in 12 stages, from the board’s decision to go public through the post-IPO quiet period. It then covers the two main alternatives: direct listings and SPACs.

Prerequisites

This note assumes familiarity with:

Why Go Public? (Stage 0)

The board weighs benefits against costs before committing.

Benefits:

  • Access to permanent capital — equity never matures; unlike debt, there is no repayment date.
  • M&A currency — publicly traded shares can be used to acquire other companies without spending cash.
  • Liquidity for existing shareholders — VCs, founders, and employees can sell their stakes on a liquid secondary market.
  • Prestige and visibility — public listing raises the company’s profile with customers, partners, and recruits.

Costs:

  • Disclosure burden — public companies must file 10-K (annual), 10-Q (quarterly), and 8-K (material events) reports under the Securities Exchange Act of 1934.
  • Sarbanes-Oxley compliance — SOX (enacted in 2002 after Enron and WorldCom) requires CEO/CFO certification of financials, internal controls audits, and whistleblower protections. Ongoing compliance costs ~$1–5M/year for mid-cap companies.
  • Quarterly earnings pressure — the market reacts to every earnings miss, incentivizing short-term thinking.
  • Litigation exposure — securities class actions are a constant risk, especially around IPO disclosures.

Selecting Underwriters — The “Bake-Off” (Stage 1)

The company invites 3-8 investment banks to pitch. Each bank presents a pitch book containing:

  • A proposed valuation (using comparable company analysis and DCF)
  • Deal structure recommendations (size, timing, exchange)
  • The bank’s equity research coverage and distribution capabilities
  • Track record of recent IPOs in the sector

The company selects a lead bookrunner — the bank that manages the order book and runs pricing — plus 2-5 co-managers who help with distribution and research coverage.

The 7% Gross Spread

The gross spread is the underwriter’s fee, expressed as a percentage of total proceeds. For deals between $20M and $80M, the spread is famously sticky at exactly 7%. Chen & Ritter (2000) documented that ~90% of moderately sized US IPOs paid precisely 7%, calling this “The Seven Percent Solution” and presenting evidence of implicit coordination among underwriters. Larger deals ($500M+) negotiate lower spreads (3–4%), but the 7% benchmark persists for mid-sized offerings.

The lead bookrunner typically receives ~60% of the gross spread. The remainder is split among co-managers based on their selling effort and allocation.

S-1 Filing (Stage 2)

The company files a registration statement (Form S-1) with the SEC under the Securities Act of 1933 — the federal law governing new securities issuances.

Key S-1 contents (per Regulation S-K, the SEC’s disclosure rulebook):

Reg S-K ItemContent
Item 101Description of business — what the company does, competitive landscape, strategy
Item 303MD&A (Management’s Discussion and Analysis) — explains financial results, trends, risks in management’s own words
Item 503Risk factors — everything that could go wrong, written by lawyers
Item 402Executive compensation — salaries, bonuses, stock grants for named officers

The S-1 also includes audited financial statements for the past 3 years (per Regulation S-X, the SEC’s accounting rules). Companies qualifying as EGCs (Emerging Growth Companies — revenue under $1.235B, as defined by the JOBS Act of 2012) can file only 2 years of audited financials, reducing preparation costs.

Confidential Filing

Since the JOBS Act (2012, originally for EGCs) and the SEC’s 2017 expansion to all issuers, companies can submit the S-1 confidentially through a DRS (Draft Registration Statement). The filing becomes public only 15 days before the roadshow. This lets companies test SEC feedback privately and withdraw without the market ever knowing they considered going public.

Due Diligence (Stage 3)

Three parallel workstreams run during the filing period:

  1. Business due diligence — underwriters interview management, verify the business model, inspect contracts, and confirm the company’s story matches reality.
  2. Legal due diligence — outside counsel reviews corporate governance, material contracts, pending litigation, IP ownership, and regulatory compliance.
  3. Accounting due diligence — the underwriter’s auditors issue SAS 72 comfort letters (Statement on Auditing Standards No. 72), confirming that unaudited financial data in the prospectus is consistent with audited statements.

This process exists for a specific legal reason: Section 11 of the Securities Act of 1933 imposes strict liability on signatories (officers, directors, underwriters, auditors) for material misstatements in the registration statement. The only defense available to underwriters is the “due diligence defense” — proving they conducted a reasonable investigation and believed the statements to be true. The landmark case Escott v. BarChris Construction Corp. (1968) established that this defense requires genuinely independent verification, not just reliance on management’s word.

SEC Review (Stage 4)

The SEC’s Division of Corporation Finance reviews the S-1 and issues comment letters — questions and requests for clarification or additional disclosure. The company responds by filing amended registration statements (S-1/A). This typically takes 3–6 rounds over 2–4 months. All comment letters and responses are eventually published on EDGAR (the SEC’s Electronic Data Gathering, Analysis, and Retrieval system — the public database of all SEC filings).

The Roadshow (Stage 5)

Once the SEC review is substantially complete, the company embarks on a ~2 week roadshow: 50–100 meetings with institutional investors (mutual funds, pension funds, hedge funds, sovereign wealth funds) across major financial centers.

The company distributes a preliminary prospectus — colloquially called a “red herring” because it carries a red-ink disclaimer on its cover stating that the registration statement has not yet become effective, the shares may not yet be sold, and the price range is preliminary. The red herring includes a proposed price range (e.g., $18–$22 per share).

During this period, the company is in a quiet period governed by Section 5 of the Securities Act (“gun-jumping” rules) and SEC Rules 168–169. The company cannot make public statements that could be construed as “conditioning the market” — no marketing the stock beyond the prospectus and roadshow presentations.

Book Building (Stage 6)

The lead bookrunner collects indications of interest (IOIs) from institutional investors during and after the roadshow. An IOI specifies a quantity and sometimes a maximum price. These are not binding — investors can withdraw at any time before allocation.

The underwriter aggregates IOIs into a demand curve: at each possible offer price, how many shares would investors want? This curve reveals both the clearing price and the quality of demand (long-term holders vs. flippers).

Pricing (Stage 7)

Pricing happens the night before the first day of trading. The lead bookrunner’s capital markets desk, the company’s CFO, and the board’s pricing committee meet to set the final offer price.

  • If demand is strong, the price is set above the preliminary range (requires a Rule 424 supplemental prospectus filing with the updated price).
  • If demand is weak, the price is set below the range or the IPO is postponed.

IPO Underpricing

One of finance’s most robust empirical anomalies: IPOs are systematically priced below their first-day trading value. The average first-day return (offer price to closing price) has been ~18% since 1980 (Ritter & Welch, 2002). During the dot-com bubble, average first-day returns hit ~65% in 1999. The 2020–21 period saw ~50%.

This “money left on the table” benefits IPO investors at the expense of the issuing company. Multiple theories compete to explain it:

  • Winner’s curse / information asymmetry (Rock, 1986) — uninformed investors need underpricing as compensation, since they get full allocations in bad IPOs but are crowded out by informed investors in good ones. (This is the same informed vs. uninformed framework that explains bid-ask spreads.)
  • Signaling — good firms underprice to signal quality, expecting to recoup in follow-on offerings.
  • Bookbuilding incentives — underwriters underprice to reward institutional investors for revealing truthful demand information during book building.
  • Underwriter conflict of interest — lower pricing reduces the underwriter’s risk and generates goodwill with buy-side clients who receive profitable allocations.

Allocation (Stage 8)

The underwriter allocates shares among investors, guided by two key FINRA (Financial Industry Regulatory Authority — the self-regulatory organization for US broker-dealers) rules:

  • FINRA Rule 5130 — prohibits allocations to “restricted persons” (industry insiders: broker-dealer employees, portfolio managers, and their families) to prevent insiders from profiting from underpriced IPOs.
  • FINRA Rule 5131 — prohibits quid pro quo allocations. Underwriters cannot allocate IPO shares in exchange for excessive trading commissions or other kickbacks. This rule emerged from the 2003 Global Research Settlement, which exposed systematic abuses during the dot-com era.

In practice, underwriters favor:

  • Long-term institutional holders (Fidelity, Capital Group, T. Rowe Price) who will hold the stock and provide price stability
  • Large asset managers with strong relationships and repeat business

Hedge funds typically receive smaller allocations (underwriters view them as more likely to flip). Retail investors generally receive less than 10% of total allocation.

First Day of Trading (Stage 9)

IPO shares begin trading on the listing exchange. The opening is not instantaneous — it involves a price discovery process:

  • On the NYSE, the DMM (Designated Market Maker — the specialist firm assigned to that stock, e.g., Citadel Securities or GTS) runs an opening auction. The DMM collects buy and sell orders, determines a price that maximizes executable volume, and prints the opening trade.
  • On Nasdaq, the opening cross serves the same function — an electronic auction matching accumulated orders at a single clearing price.

This process typically takes 1–3 hours after the market opens at 9:30 AM ET. The delay is longer for hot IPOs with significant demand imbalance.

The difference between the offer price (e.g., $20) and the opening print (e.g., $28) is the “pop” — the visible manifestation of IPO underpricing.

Stabilization and the Greenshoe Option (Stage 10)

For up to ~30 days after the IPO, the lead underwriter can engage in stabilization activities under Regulation M Rule 104 — buying shares in the open market to prevent the price from falling below the offer price.

The Greenshoe (Over-Allotment Option)

Named after the Green Shoe Manufacturing Company, whose 1960s IPO first used this mechanism. Here is how it works:

  1. The issuer grants the underwriters an option (not an obligation) to purchase up to 15% additional shares at the offer price within 30 days.
  2. On IPO day, the underwriter sells 115% of the deal size — 100% from the issuer plus a 15% short position.
  3. If the stock trades above the offer price: the underwriter exercises the greenshoe, buying 15% from the issuer at the offer price and delivering those shares to cover the short. Everyone is happy — the issuer raised more capital, the underwriter earned additional spread.
  4. If the stock trades below the offer price: the underwriter buys shares in the open market (providing price support) and does NOT exercise the greenshoe. The short is covered at below-offer prices, generating a trading profit for the syndicate.

This is an elegant structure: it functions as a costless put option for the underwriter. The underwriter profits in both the up and down scenarios, and the issuer benefits from either additional capital (up) or price support (down).

Aggarwal (2000) documented that approximately 50% of IPOs experience stabilization activity, with the greenshoe/syndicate short covering being the primary mechanism.

Regulation M in Detail

Regulation M governs the conduct of underwriters and other distribution participants around securities offerings:

RuleWhat It Does
Rule 101Restricts underwriters from bidding for or purchasing the security during the “restricted period” (1-5 business days before pricing, depending on the security’s float and trading volume)
Rule 104Permits stabilizing bids at or below the offer price, provided they are disclosed in the prospectus and reported to the exchange. This is the legal basis for post-IPO stabilization
Rule 105Prohibits covering a short position established within 5 business days before pricing with shares from the offering. Prevents manipulation where a trader shorts the stock, then covers with cheaper IPO shares

Lock-Up Period (Stage 11)

For 180 days after the IPO, company insiders (founders, executives, directors), employees, and pre-IPO investors (VCs, PE firms) are contractually prohibited from selling their shares. This is not an SEC regulation — it is a contractual agreement between the company, the underwriters, and the locked-up shareholders.

The lock-up exists because a wave of insider selling immediately after the IPO would overwhelm demand and crash the stock. By spreading out the supply increase, the lock-up gives the public market time to absorb the float.

Lock-up expiration is a well-studied event. Field & Hanka (2001) documented average negative abnormal returns of ~2% around lock-up expiration, as the market anticipates the surge in sell-side supply. The effect is larger for VC-backed IPOs, where pre-IPO investors have strong incentives to distribute returns to their LPs (Limited Partners — the investors who committed capital to the VC fund).

Post-IPO Quiet Period (Stage 12)

For 25 days after the IPO, the underwriting syndicate’s research analysts cannot publish research reports on the newly public company. This prevents the perception that analyst research is a marketing tool for the investment banking relationship.

The JOBS Act shortened this period from 40 to 25 days for EGCs. After the quiet period expires, the underwriting banks typically initiate coverage simultaneously — often with Buy or Outperform ratings, which is one reason investors treat IPO-initiating coverage with skepticism.

Alternative Paths to Public Markets

Direct Listings

In a direct listing, no new shares are issued and no underwriter manages the deal. Existing shareholders (employees, VCs, founders) sell their shares directly into the public market on the first day of trading.

Mechanics:

  • No roadshow, no book building, no allocation process.
  • The opening auction (NYSE DMM call or Nasdaq Cross) sets the first trading price. There is no “offer price” — price discovery happens entirely in the auction.
  • No lock-up period — all existing shareholders can sell from day one.
  • A financial advisor (not an underwriter) helps with SEC filings and listing requirements.

Primary direct listings: since late 2020 (SEC approved NYSE’s proposal in December 2020, Nasdaq’s in August 2021), companies can raise new capital in a direct listing by selling newly issued shares directly into the opening auction. This closes the main historical gap between direct listings and traditional IPOs.

Notable direct listings: Spotify (2018), Slack (2019), Coinbase (2021), Roblox (2021).

Traditional IPODirect Listing
New capital raisedYesOnly in primary DL (since 2020-21)
UnderwriterYes (7% spread)No (financial advisor only)
Price discoveryBook building + pricing meetingOpening auction
Lock-up180 days (contractual)None
Underpricing/“pop”~18% averageMarket-determined; no systematic pattern
Price supportYes (greenshoe + stabilization)None
Institutional allocationUnderwriter-controlledOpen market

Tradeoffs: direct listings eliminate underpricing and dilution, but provide no price support, no guaranteed institutional investor base, and — for non-primary direct listings — no new capital. They work best for well-known companies (strong brand = natural demand) that don’t need to raise cash.

SPACs (Special Purpose Acquisition Companies)

A SPAC is a shell company — it has no business operations. It IPOs to raise cash, which is placed in a trust, and then has 18–24 months to find and acquire a private company (the “target”). The target effectively goes public through the merger without running a traditional IPO.

SPAC IPO structure:

  • Investors buy units, typically at $10 each. Each unit contains one share of common stock plus a fraction of a warrant (a long-dated call option on the SPAC’s stock, usually exercisable at $11.50).
  • The SPAC sponsor (the team that created the SPAC) typically receives a promote — 20% of the post-IPO shares for a nominal investment. This is the sponsor’s incentive to find and close a deal.

The de-SPAC process:

  1. The SPAC identifies a target and negotiates a merger agreement.
  2. SPAC shareholders vote on the deal. Shareholders who don’t like the target can redeem their shares for the trust value (~$10 + interest).
  3. If approved, the merger closes and the target company’s shares begin trading under the SPAC’s ticker (usually renamed).

If no deal closes within the deadline, or if shareholders vote the deal down, the trust cash is returned to shareholders. The sponsor’s promote becomes worthless.

Rise and fall: SPAC IPOs peaked at ~600 in 2021, driven by low interest rates, retail enthusiasm, and celebrity sponsors. Performance has been poor — studies show median post-merger SPAC returns below Treasury bills, largely due to dilution from warrants and the sponsor promote. The SEC adopted new rules in March 2024 requiring enhanced disclosures, explicit dilution tables, and aligning de-SPAC targets with IPO-level liability (target companies can no longer avoid the stringent disclosure standards of a traditional S-1).

Traditional IPOSPAC
Timeline to public6-12 months3-5 months (de-SPAC after SPAC already exists)
Price certainty for targetNo (market sets price)Yes (negotiated valuation)
DilutionUnderwriting spread (7%)Warrants + sponsor promote (can exceed 30%)
Regulatory scrutiny of targetFull SEC S-1 reviewHistorically lighter; post-2024 rules closing gap
Post-listing performanceMixed (varies by company)Generally poor (median below T-bills)

Key Academic References

SourceFinding
Chen & Ritter (2000), Journal of Finance”The Seven Percent Solution” — 90% of mid-sized IPOs pay exactly 7% gross spread, suggesting implicit coordination
Ritter & Welch (2002), Journal of FinanceAverage first-day IPO return of ~18% since 1980; surveys theories of underpricing
Aggarwal (2000), Journal of Finance~50% of IPOs experience stabilization; greenshoe/syndicate short covering is the primary mechanism
Field & Hanka (2001), Journal of Finance~2% negative abnormal returns at lock-up expiration; larger for VC-backed IPOs
Escott v. BarChris Construction Corp. (1968)Landmark case establishing that Section 11’s due diligence defense requires genuinely independent investigation

See also

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