How an IPO Works
Investment banks underwrite stock and bond offerings. That is, they purchase either a portion of, or the entire issue, in order to ensure that the cash the client needs will be raised. The bank then immediately sells the securities to clients at a slightly higher price (the difference is called the spread). It is the bank's goal to accurately price an offering, or perhaps to price it at a little bit below its true market value. Say an investment bank has convinced a company that it should go public by issuing one million shares at $30 a share. After the shares hit the market, they balloon to $40 a share. The company is somewhat disappointed because it could have generated an additional $10 million more from the public (one million shares x $50). The bank's clients are pleased because they bought a stock at well under market value. The rationale for this under-pricing? If the bank values the company at just under its market value, its clients will receive a nice immediate boost, and the company has generated good buzz for its shares because the offering is viewed as successful.