When a Company Goes Public, Why Can Only a Few Investors Invest?

When a company decides to go public, it marks a significant shift in its financial journey. This transition allows the business to raise capital from the public market while offering investors an opportunity to own a piece of the enterprise. However, not all interested parties can invest during this initial phase.

The exclusivity surrounding initial public offerings (IPOs) often leaves many potential investors on the sidelines. Understanding why only a select group gains access is crucial for those navigating the investment landscape.

IPO Allocation and Share Distribution

The process of IPO allocation and share distribution involves the issuing company, underwriters, and potential investors. A large portion of shares is typically reserved for institutional investors, such as mutual funds, pension funds, and insurance companies, due to their ability to purchase large blocks of shares. This preference is guided by underwriters, who assess demand and set the initial price range.

Institutional investors are favored for their purchasing power and perceived stability, which can lend credibility to the IPO and attract additional interest. The allocation process is governed by regulations like the Securities Act of 1933, which mandates full disclosure to protect investors. Some companies, particularly in the tech sector, may allocate a larger percentage to retail investors to build a broader shareholder base.

Retail investors often face challenges in accessing IPO shares due to high demand and limited availability. To address this, mechanisms like directed share programs reserve shares for employees and other stakeholders. Platforms like Robinhood have attempted to broaden access by allowing retail investors to participate in IPOs directly. Despite these efforts, the allocation remains competitive, with many retail investors receiving fewer shares than requested.

Underwriter Involvement

Underwriters play a central role in the IPO process, acting as intermediaries between the company and the public. Their primary responsibility is to ensure the successful issuance of shares, which involves understanding market conditions and investor demand. Investment banks typically serve as underwriters, conducting due diligence to assess the company’s financial health and prospects while setting a realistic price range for shares.

A key aspect of their role is the underwriting agreement, which outlines the terms for purchasing and distributing shares. This agreement often includes a firm commitment to buy the entire issue and resell it to the public, assuming significant risk. If demand is lower than expected, underwriters may have to purchase unsold shares, impacting profitability. To manage this risk, underwriters may employ a greenshoe option, allowing them to sell additional shares if demand exceeds expectations, stabilizing the share price post-IPO.

Underwriters also determine the allocation of shares, balancing the interests of institutional and retail investors. Using a book-building process, they collect bids from potential investors and adjust the price based on demand. This process helps ensure shares are priced appropriately and that there is sufficient demand to support the share price after the IPO.

Types of Shares Issued

When a company goes public, it typically issues common and preferred shares, each appealing to different investor profiles. Common shares represent ownership in the company and usually come with voting rights, allowing shareholders to influence corporate decisions. Dividends for common shares, however, are variable and depend on the company’s profitability.

Preferred shares offer a fixed dividend, making them attractive to investors prioritizing income over control. While these shares often lack voting rights, they provide a higher claim on assets and earnings, which can be advantageous in liquidation scenarios. Some preferred shares are convertible, allowing investors to exchange them for common shares, offering flexibility and potential capital gains if the stock price rises.

Companies might also issue restricted or performance shares, typically awarded to executives and employees as part of compensation packages. These shares often include vesting conditions tied to financial performance or tenure, aligning management’s interests with those of shareholders. The issuance of such shares is regulated by the SEC’s Rule 144, which sets conditions for selling restricted securities.

Retail Investor Access

Navigating the IPO landscape as a retail investor can be challenging, with opportunities often overshadowed by barriers. Historically, retail investors faced hurdles due to the intricate allocation process and the dominance of institutional investors. However, the financial ecosystem has evolved, using technology and regulatory changes to enhance inclusivity. Platforms like SoFi and Robinhood have pioneered efforts to provide retail investors direct access to IPOs, partly driven by the JOBS Act, which encourages broader participation by reducing regulatory burdens on smaller companies.

Despite these advancements, challenges remain. Retail investors often encounter limited availability of shares, frequently receiving fewer than requested. This scarcity stems from high demand and the preferential treatment of institutional investors. Still, retail investors are increasingly leveraging online brokerage platforms that provide IPO access, though often with restrictions such as minimum account balances or holding periods. These platforms typically operate on a first-come, first-served basis, requiring investors to act quickly to secure shares.