By Adam Bean, BallooningNestEggs.com

Adam Bean is a writer for Ballooning Nest Eggs. He’s now channeling his interest in adventure and lifestyle reporting to his first start-up, Ballooning Nest Eggs.

Given the huge hype surrounding Facebook’s IPO in mid May, it’s quite likely the young investor-to-be in your life is wondering what is an IPO? At Ballooning Nest Eggs, we want to help you help your nieces and nephews understand both the hype and what may be an opportunity for investing. Here’s a brief primer on the mysterious, behind-closed-doors moment when a privately owned company becomes publicly traded on a stock exchange.

Okay, I give up, what does “IPO” stand for?

It stands for “initial public offering,” as in the first sale of a company’s shares of stock to the public.

Have IPOs existed for a long time, or are they something Facebook invented, along with “personal profiles,” “friends,” and “walls?”

IPOs have been around for more than 400 years! The first firm to hold an IPO was the famous Dutch East India Company in 1602. (To put that in context, that’s when the first Queen Elizabeth was on the throne in England.) A company based in the Netherlands, the Dutch East India Company dominated trade with Asia at that time, and was essentially the world’s first multinational corporation. It was this company which commissioned English captain Henry Hudson to explore what became America.

Why does Facebook, or any other company, decide to sell its shares of stock to the public in the first place?

It’s a way to raise a lot of money to make big improvements, add new products and services, and that sort of thing. Becoming a public company also builds and diversifies the company’s ownership mix, allows it to raise and spend money quickly should the need arise, and increases the company’s public profile and prestige.

So, why doesn’t every company go public?

Because public ownership resulting from an IPO brings about the phenomenon called “too many cooks in the kitchen.” That is, a lot more people are involved in the big decisions the company makes, which can cause bottlenecks and inefficiency. A publicly owned company must follow government laws surrounding public companies; this means it must spend a lot more time and energy telling people how it’s doing, if it’s healthy or unhealthy, and what its next moves will be. And there’s always the chance that an IPO will generate less money than was expected, which is embarrassing and can significantly damage a company’s image.

What happens during an IPO?

To help things go smoothly, a company usually gets a big bank or banks to help sell the stock (this job is called “underwriting”). And because of so many legal and regulatory requirements imposed by the United States and state governments, there are usually one or more law firms that help with the sale as well. These banks and law firms always get a “cut” or percentage of the money made by the sale. The company’s leadership sets the price of the shares it is selling, decides on an IPO date, and the sale happens.

By the way, the value of a company generally dictates what its shares are worth when they are sold on the first day. A highly valued and profitable company like Facebook can sell each of its stock shares for as much as $35 or more. That equates to a lot of money raised by the IPO, because Facebook is talking 400 million shares!

Can a company be trusted to set a fair price for its stock?

This can be a tricky proposition, because the hype and popularity surrounding a company during its IPO sometimes skews its actual value and ability to make a profit. Many experts believe this may be the case with Facebook. Even though the company made $1 billion in profit in 2011, some believe its value does not justify an initial share price of $35. Only time will tell, and it could take years for this to become clear.

How will we know?

By tracking Facebook’s share price over time. When the value of a company falls, its share price falls as well. Thus the share price acts as an important “barometer” for how the company is doing. For example, if an investor buys 1,000 shares at an IPO for $20 a share, he or she will have invested $20,000. But if in two years the value of that company’s stock goes down—for instance, maybe people don’t like its new line of products—its share price may drop to $10 a share. That means the original investment of $20,000 is now worth just $10,000 if the investor trades in those stocks for cash.

Hmm, that’s scary. That’s a lot of money to lose!

Yes, it is, and it’s why you need to be very careful, do a lot of research, and keep a cool head when you invest your money in a company, a mutual fund, or anything else.

How do you feel about investing in an IPO? Share your thoughts on Ballooning Nest Eggs Facebook page.

Published: May 28, 2012