An IPO is the process whereby a private company becomes a public company. Public offerings raise capital for the company and give the general public an opportunity to invest in the company by buying its shares.

Though there are variations in how this occurs, in a typical offering, a company enlists the help of one or more investment banks to underwrite their offering. This means that the banks make a guarantee to the company that they will purchase all of the shares being offered at the IPO price on the day of the IPO. The underwriters, of course, do not intend to keep all of the shares themselves. With the help of the offering company, they go on what's called a roadshow to drum up interest from institutional clients. These clients put in a subscription for the shares, which indicates their interest in buying shares on the day of the IPO. This is a non-binding contract, as the price of the offering is not finalized until the day of the IPO. The underwriter will then set the offer price, given the level of interest expressed.

What is interesting from our perspective is that research has consistently shown a systematic underpricing of IPOs. There are a number of theories as to why this happens, and why this level of underpricing seems to vary over time, but studies have shown that billions of dollars are left on the table every year.

In an IPO, money left on the table, is the difference between the offering price of shares and the first day's closing price.

One other point that should be mentioned before we move on is the difference between the offering price and the opening price. While you can occasionally get in on the deal through your broker and receive the IPO at its offering price, in nearly all instances, you, as a member of the general public, will have to purchase the IPO at the (typically higher) opening price. We'll build our models under this assumption.