How an IPO actually works

An IPO, or initial public offering, is the first time a private company sells its stock to the public. The basic path looks like this:

• The company files paperwork with the SEC (a document called an S-1) that lays out its finances, risks, and plans.
• After the SEC reviews it, the company and its banks travel around pitching the deal to large investors. This is called the roadshow.
• The banks gather demand, then set a final offer price the night before trading begins.
• Shares are handed out to chosen investors at that offer price.
• The next morning, the stock opens for everyone else to trade.

The key thing to understand: the offer price is a negotiated guess, not a real market price. The real price only shows up once public trading starts, which is why the stock can jump or drop right out of the gate.

Who gets the good seats

There are really four groups in any IPO, and they do not all sit on the same side of the table:

• The company and its insiders. Founders, employees, and early investors. Sometimes an IPO raises money to grow the business. Sometimes it mostly lets insiders cash out.
• The banks (underwriters). They price the deal, hand out the shares, and support the stock early on. They get paid to get the deal done.
• Institutions. Mutual funds, pension funds, and hedge funds. These big players get most of the shares at the offer price. Fidelity notes a typical split is roughly 90% to institutions and 10% to everyone else.
• You, the retail investor. The SEC is blunt about this: regular individuals usually cannot buy at the offer price and instead buy later, in the open market, after the stock has already moved.

That last point is the whole ballgame. If the stock has already popped, you are not getting the deal that made the headline.

Why the stock often “pops” on day one

You may have heard that banks deliberately price IPOs a little low. That is true, and it is called underpricing. The banks set the offer price below what they expect the market to pay, so the stock rises on opening day. There are a few reasons:

• It rewards the big clients who got shares at the offer price, keeping those relationships strong.
• It guarantees the deal sells out, so the bank is not stuck holding unsold stock.
• It pays investors for honest feedback during the roadshow about how much they would pay.

Over the long haul, this adds up. University of Florida professor Jay Ritter, who tracks this data, found the following:

The catch: that gain belongs to whoever bought at the offer price. Not necessarily retail investors.

The catch behind the “winners”: adverse selection

If you do manage to get an allocation at the offer price through your brokerage, the deals that are more readily available tend to be the weaker ones. If you are not being solicited IPOs on a regular basis then this may be an indication that there is more supply than demand for that offering.

Researchers call this adverse selection, and the logic is simple once you see it:

• The banks know which deals are hot and which are not.
• The genuinely hot IPOs, the ones likely to pop, get reserved for the banks’ best and biggest clients (think Ultra-High Net-worth or Institutional).
• The leftover shares, the ones easy for a regular investor to grab, are disproportionately the deals that go on to perform poorly on day one.

In plain terms: when you are easily handed shares, this could be a warning sign, not a lucky break. The shares that are hardest to get are usually the ones worth having, and those rarely reach the average household. So the headline “IPOs pop on day one” is true on average, but the gains are not spread evenly, and everyday investors may end up holding the deals nobody fought over.

What the research says happens next

This is the part the news skips. Once the opening excitement fades, the average IPO has historically trailed similar, established companies. Ritter’s data (measured from the first day’s closing price, so the pop is already removed) compares IPOs against size-matched companies. The figures below are annualized, meaning the return for that single year:

In plain terms, in almost every year after listing, the average IPO earned less than a comparable company already trading on the market.

A separate study from Dimensional Fund Advisors reached the same conclusion using a different method. They looked at more than 6,000 U.S. IPOs from 1991 to 2018 and built a portfolio of newly public stocks:

Dimensional’s explanation is worth remembering: most IPOs are small, fast-growing, unprofitable companies, and those traits have historically come with lower returns, not higher ones. The exciting story and the actual math point in opposite directions. It is a good reminder of why building a diversified portfolio tends to beat chasing individual standout names.

The lockup trap

Here is one more thing to watch. When a company goes public, insiders usually agree not to sell their shares for a set period, often about 180 days. This is called the lockup.

That means in the first few months, only a small slice of shares is actually trading, which can keep the price propped up. When the lockup ends and insiders are free to sell, the extra supply can push the price down. Research from Bradley, Jordan, Roten, and Yi found stocks tend to dip around lockup expiration, with the effect strongest in venture-backed companies.

So even an IPO that looks strong at first may be running on a temporarily limited supply of shares.

How we think about it at Babb

A fiduciary approach starts with a different question. Not “Is this exciting?” but “Does this fit your written plan?”

The reason matters. The banks, the insiders, and the big institutions all have their own goals, and those goals do not include your retirement. An average household is usually trying to fund a comfortable future, manage taxes, and avoid costly mistakes made out of excitement or fear. Chasing a hot IPO rarely serves any of those.

There is also a bigger lesson here. A single new stock, IPO or not, concentrates your risk in one company’s story. We have written more about the risks of holding too much in one stock, why spreading your money out matters, and what employees with concentrated company stock should think about. The pattern is consistent: spreading your money out has been the more reliable path.

None of this means an IPO can never belong in a portfolio. It means the smart time to look is usually after the dust settles, after the lockup calendar is clear, and after you know how it fits everything else you own.

Frequently asked questions

This article is for educational purposes only. It is not investment, tax, or legal advice and does not constitute a recommendation to buy or sell any security. Past performance is not a guarantee of future results. Individuals should consult a qualified advisor before making investment decisions. Opinions contained herein are subject to change without notice.