How IPOs Work | How Do Stocks Work?

An initial public offering (IPO) is the first time a company sells its shares to the general public, usually with investment banks managing the sale, after which the shares start trading on a stock exchange. It is how a private company becomes a public one.

In short: in a traditional IPO, the company hires underwriters, files a detailed disclosure document with securities regulators, markets the shares to big investors in a roadshow, and sets a price based on their orders (book building). The banks buy the shares at a discount and resell them to investors at the offer price. Insiders usually agree not to sell for a period afterwards (a lock-up). Then the shares trade on an exchange like any other.

Why companies go public

To raise money for growth, research, or paying down debt.
To let early owners sell. Founders, employees, and venture investors can eventually turn private stakes into cash.
To get a currency. Public shares can be used to pay for acquisitions and to compensate employees.

The costs are real: underwriting fees, legal and accounting bills, ongoing disclosure obligations, and the scrutiny that comes with a public share price.

The traditional IPO, step by step

1. Hire the underwriters

The company picks one or more investment banks. The lead banks (bookrunners) run the process, advise on price, and take on the job of selling the shares. In a typical US “firm commitment” deal, the underwriters agree to buy all the shares from the company at a discount to the offer price and resell them to investors.

That discount is the gross spread, the banks’ main fee. Research by University of Florida professor Jay Ritter has documented for decades that US IPOs of moderate size cluster at a gross spread of exactly 7%. Very large deals typically pay less.

2. File the disclosure document

United States. The company files a registration statement, usually on Form S-1, with the SEC. It describes the business, risks, financial statements, management, and how the money will be used. Many companies first submit drafts confidentially for SEC staff review, and make the filing public before marketing. The preliminary version given to investors is sometimes called a “red herring,” after the red-ink legend saying it is not final. Shares cannot be sold until the SEC declares the registration statement effective.

Canada. The company files a preliminary prospectus with the securities regulator in each province and territory where it will sell shares, through SEDAR+. Once the regulator issues a receipt, the waiting period begins: the company and dealers can market the offering under National Instrument 41-101, but can’t sell until a receipt is issued for the final prospectus. Canadian companies often list on the TSX or, for smaller companies, the TSX Venture Exchange. Many large Canadian companies list in both countries.

These filings are where you find what you need to judge an IPO; how to read a 10-K explains the sections that matter, and they are similar in an S-1 or prospectus.

3. The roadshow and book building

Management and the bankers present to institutional investors, usually over a week or two. Investors put in indications of interest: how many shares they would buy at what price. The bookrunners collect these into a “book.”

If demand is strong, the price range can be raised and the deal upsized. If it’s weak, the price is cut or the IPO is postponed.

4. Pricing and allocation

The night before trading starts, the company and the bookrunners set the offer price and decide who gets shares. Most shares in large IPOs go to institutions. Some brokers offer retail access to IPO shares, but allocations in popular deals are often small.

5. First day of trading

The next morning, the exchange runs an opening auction to set the first trading price. From there, the stock trades in the secondary market, where the company no longer receives the money; see how the stock market works.

A worked example

Maple Widgets Inc. (hypothetical) sells 10,000,000 new shares at an offer price of $20.00, with a 7% gross spread.

	Amount
Gross proceeds: 10,000,000 × $20.00	$200,000,000
Gross spread: 7% × $200,000,000	$14,000,000
Net to the company (before legal, audit, and listing costs)	$186,000,000
Spread per share: 7% × $20.00	$1.40

So the banks pay the company $18.60 per share and sell to investors at $20.00.

The greenshoe. The underwriters also get an over-allotment option, often called the greenshoe, to buy up to 15% more shares from the company at the offer price (FINRA rules cap it at 15%). They typically sell those extra shares at the IPO, creating a short position. If the stock trades well, they exercise the option, and the company sells 1,500,000 more shares, raising another 1,500,000 × $18.60 = $27,900,000 net. If the stock falls below $20.00, the banks instead buy shares in the market to cover their short, which supports the price. This is the main form of IPO price stabilization.

The first-day pop. Suppose Maple Widgets closes its first day at $25.00, up 25% from the offer price.

Investors who got shares at $20.00 are up $5.00 per share.
The difference between the first-day close and the offer price, multiplied by the shares sold, is called money left on the table: 10,000,000 × ($25.00 - $20.00) = $50,000,000. That is value the company could have captured at a higher offer price.

First-day pops are typical, not exceptional. Ritter’s data show an average first-day return of 19.1% across 2,824 US IPOs from 2001 to 2025. Averages are pulled up by big winners. Many IPOs rise only a little, and some fall below their offer price on day one.

Lock-ups

Insiders and pre-IPO investors usually sign lock-up agreements with the underwriters, promising not to sell for a set period. 180 days is the most common length. Lock-ups are contracts, not laws, and the banks can waive them or the agreement can release shares early in stages.

When a lock-up expires, a large number of shares can become available to sell at once. Prices sometimes weaken around expiry dates, which are disclosed in the prospectus.

Alternatives to a traditional IPO

Direct listings

In a direct listing, a company lists its existing shares on an exchange without underwriters buying and reselling a block. There is no offer price; the first trade comes from the exchange’s opening auction. Spotify’s NYSE listing in April 2018 was the best-known early example. Originally, direct listings did not raise new money. In December 2020, the SEC approved an NYSE rule allowing a company to sell new shares in the opening auction of a direct listing, and Nasdaq later adopted a similar rule. Direct listings have no traditional lock-up by default, though companies can impose restrictions.

SPACs

A special purpose acquisition company (SPAC) is a shell company that raises money in its own IPO, holds the cash in a trust account, and then looks for a private company to merge with (the “de-SPAC”). The private company becomes public through the merger rather than through its own IPO. SPAC investors can usually redeem their shares for their portion of the trust before the merger closes.

SPACs boomed in 2020 and 2021. The SEC adopted new rules in January 2024, effective July 1, 2024, requiring more disclosure about sponsor compensation, conflicts of interest, and dilution. The TSX also allows SPAC listings. The key thing to understand is that SPAC sponsors typically receive a large stake for a small investment, which dilutes other shareholders.

Reading the numbers in an IPO filing

A few figures in the “Offering,” “Use of Proceeds,” and “Dilution” sections of an S-1 or prospectus tell you most of what you need.

Say Maple Widgets had 40,000,000 shares before the IPO, held by founders, employees, and venture investors, and sells 10,000,000 new shares at $20.00.

Shares outstanding after the IPO: 40,000,000 + 10,000,000 = 50,000,000.
Market capitalization at the offer price: 50,000,000 × $20.00 = $1,000,000,000. A $200 million deal values the whole company at $1 billion.
Public float: the 10,000,000 IPO shares are 10,000,000 ÷ 50,000,000 = 20% of the company. Insiders still hold 80%, much of it under lock-up.
Who gets the money: if some of the shares sold come from existing holders (a “secondary” component), that money goes to them, not the company. The filing separates the two.
Use of proceeds: what the company says it will do with the money, from paying down debt to “general corporate purposes.”
Dilution: new investors usually pay far more per share than the company’s net tangible book value per share, and the filing calculates that gap.

A small float matters. When only a fifth of the shares can trade, a burst of demand can push the price around, and a lock-up expiry can sharply increase the number of shares available for sale.

What can go wrong

You may not get the offer price. Most retail buyers buy on the first day in the secondary market, after the pop. Buying at $25 rather than $20 changes the math entirely.
Limited history. A newly public company has fewer years of audited results, and the prospectus is written by the company and its bankers.
Lock-up expiries can add selling pressure months later.
Long-run performance. Academic research on US IPOs, including Ritter’s, has found that newly public companies as a group have tended to underperform comparable established companies over the following few years, though results vary widely by period and by company.
Hype. Popular IPOs can attract heavy media coverage, which can push first-day prices well above what the business has demonstrated. The broader picture is in stock market risks explained honestly.

If you do buy a new listing in its first days of trading, a limit order caps the price you’ll pay; see stock order types.

The takeaway

An IPO turns a private company into a public one. Underwriters price the deal by gathering big investors’ orders, buy the shares at a discount (often 7% for mid-sized US deals), and resell them; regulators in the US and Canada require a detailed disclosure document first. First-day pops are common but go mostly to those allocated shares at the offer price. Lock-ups, direct listings, and SPACs are variations worth understanding before buying any new listing.