What Is a Good IPO?

When a company goes public, we often hear about if an IPO was "successful" or not. That is usually determined in the media's eyes by whether the stock rose on its first day of trading. Big gainers like Groupon (Nasdaq: GRPN  ) or LinkedIn (NYSE: LNKD  ) are considered "successful" because they popped when they went public.

But does that really make an IPO successful? It depends on whom you ask.

The bankers and big initial buyers
When a company goes public, investment banks like JPMorgan (NYSE: JPM  ) , Citigroup (NYSE: C  ) , and Goldman Sachs (NYSE: GS  ) work with the company to set a price, and then they shop the deal to clients. These clients are mostly large institutional investors like hedge funds that have lots of capital and trade with the bank often.

For buyers of shares, it's easy to see why a fast-rising price is deemed successful. IPO buyers can sell off shares or hedge their positions for a quick profit, and the client is happy.

For investment banks, it's a bit more complicated. The bank gets a percentage of the offering proceeds as a fee, but it is also normally offered a portion of shares (usually 15%) for overallotment. If the stock rises on Day 1, the bank can short the stock and turn around and buy shares at the original offer price from the company. This is one way IPOs can make big money for investment banks.

The company going public
But what about the company that actually sold shares? If the stock rises the day trading opened, that's money the company left on the table that could have been used to fund operations. A successful IPO in the company's eyes should really be a stock that is offered at a price higher than the stock trades a! t on Day 1.

But since an investment bank has a vested interest in an IPO having a good performance early in its life, for both itself and its clients, why wouldn't it err on the side of underpricing an IPO? It just makes good business sense.

There are other ways to go public, like a Dutch auction that Google (Nasdaq: GOOG  ) used for its IPO. The auction welcomes all bidders and is priced at the lowest price that equals the number of shares being released to the public. This process also keeps investment banks from controlling the process too much and making money on an underpriced IPO.

Who wins?
In the end, the success of an IPO depends on which side of the deal you're on. Investment banks and their clients want a stock to soar early in its life and think a pop on opening day is successful. A company would prefer to see the stock drop, indicating that it was actually paid too much for its IPO.

As retail investors, we're often just along for the ride. But as Alex Planes has pointed out this week, most IPOs have been losers for long-term retail investors this year. The bottom line is that buyers should beware.