How IPOs Actually Work: Pricing, Allocation, and What Interviewers Expect You to Know
9 min read
- An IPO does not value a company from scratch. It takes an existing valuation (from comps, DCF, or private rounds) and adjusts it for public market pricing.
- IPO shares are priced at a 10-25% discount to the expected trading value. This discount compensates institutional investors for taking allocation risk and guarantees the deal clears.
- Primary shares raise new capital for the company. Secondary shares are existing investors selling their stakes. Only primary proceeds go to the company's balance sheet.
- The greenshoe (overallotment option) allows banks to issue ~15% additional shares if demand is strong, stabilising the stock in the aftermarket.
The Core Insight Most Candidates Miss
An IPO is not a valuation exercise. The company has already been valued through private funding rounds, through the bank's own DCF and comps analysis, and through the management roadshow. The IPO process takes that valuation and translates it into a price per share that institutional investors are willing to pay on day one.
The translation involves a deliberate discount. If the bank's analysis suggests the company should trade at £40 per share, the IPO is priced at roughly £32-36. This discount exists because:
- Institutional investors (the ones who receive IPO allocations) demand compensation for the risk that the stock drops below the offering price
- A successful "pop" on day one (stock opens above the IPO price) generates positive press coverage and builds momentum for the stock
- The bank's reputation depends on the deal not breaking (trading below the IPO price). Underpricing is safer than overpricing.
How IPO Pricing Works: Five Steps
Primary vs Secondary Shares
This distinction is tested in interviews and frequently confused:
| Type | What Happens | Who Benefits | Balance Sheet Impact |
|---|---|---|---|
| Primary shares | New shares are created and sold to IPO investors | The company — proceeds go to the balance sheet | Cash increases; equity increases; share count increases |
| Secondary shares | Existing shareholders sell their shares to IPO investors | The selling shareholders (founders, VCs, PE firms) | No impact — cash and equity unchanged; ownership transfers |
A typical IPO includes both. The company raises capital through primary shares, and early investors partially exit through secondary shares. The mix matters: an IPO that is heavily secondary (existing investors dumping their stakes) sends a negative signal about insider confidence.
The Greenshoe (Overallotment Option)
The greenshoe is a mechanism that allows the underwriting bank to issue up to ~15% additional shares beyond the original offering, exercisable within 30 days of the IPO.
How it works in practice:
- The bank actually oversells the IPO by 15% from the start, creating a short position
- If the stock rises after the IPO, the bank exercises the greenshoe option: it buys the additional shares from the company at the IPO price and delivers them to the investors who were oversold. The company raises more capital.
- If the stock falls, the bank does not exercise the option. Instead, it buys shares in the open market (at the lower price) to cover the short position. This buying activity supports the stock price — the stabilisation mechanism.
The Three-Statement Impact of an IPO
| Statement | Impact |
|---|---|
| Income Statement | No immediate impact on revenue or operating income. EPS changes because the share count increases (dilutive unless earnings grow proportionally). One-time IPO-related costs (legal, accounting, underwriting) may appear as an expense. |
| Balance Sheet | Cash increases by net primary proceeds (gross proceeds minus underwriting fees and IPO costs). Equity increases by the same amount. Share count increases. |
| Cash Flow Statement | Financing inflow equal to net primary proceeds. No impact from secondary shares (cash goes to sellers, not the company). |
Interview Questions
"Walk me through the IPO process."
The company hires an investment bank (the underwriter). The bank conducts due diligence and prepares the prospectus (S-1 in the US, equivalent filings in the UK). The company and bank go on a roadshow, presenting to institutional investors to gauge demand. Based on investor feedback, the bank sets the offering price range, then the final price. Shares are allocated to institutional investors. The stock begins trading on the first day. The bank stabilises the aftermarket using the greenshoe if needed.
"Why would a company go public?"
To raise capital for growth (acquisitions, R&D, expansion), to provide liquidity for early investors (VCs, PE firms, founders who want to monetise some of their stake), to create a publicly traded currency for future M&A (stock-for-stock deals), and to increase the company's profile and credibility with customers, partners, and employees (who can receive tradeable stock options).
"Why might a company choose NOT to go public?"
Regulatory and compliance costs are significant (Sarbanes-Oxley in the US, ongoing disclosure requirements). Public companies face quarterly earnings pressure that can distort long-term decision-making. Information that was previously private (compensation, margins, customer concentration) becomes public. Founders lose control as public shareholders gain influence. For many companies, private capital markets (PE, growth equity, venture) now provide the same capital at lower cost and lower disclosure burden.
"What is an IPO discount and why does it exist?"
The IPO discount is the gap between the expected trading value and the actual offering price, typically 10-25%. It exists to compensate institutional investors for allocation risk, to create a positive first-day return that builds momentum, and to protect the bank's reputation. The discount is a cost to the company (it receives less per share than the stock is worth) and a transfer of value to the institutional investors who receive the allocation.
Take Your Preparation Further
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