Not since Ford went public in the 1950s has an American automaker gone to the equity markets for an initial public offering (IPO). But, on Monday, Tesla Motors did just that. I thought Tesla, which now trades on the NASDAQ exchange under the ticker: TSLA, would be a great showpiece for how IPOs work.

So first, what is an IPO?

Every company that trades on an exchange such as the New-York Stock Exchange or the NASDAQ, has at some point or another, gone through an initial public offering.

99.99999999999999% of all companies start out as privately held. Maybe there was a founder and a group of private investors that all went in together or something. You can learn more about this kind of financing here. But eventually, those initial financiers want to get their money back. They have a few options, but they basically boil down to selling to some other private investor or selling to the public. Selling to the public is the IPO.

When you go public, you will usually hire 1 or more investment banks to underwrite the IPO. The investment bank will evaluate how much your company may be worth, and then goes and finds investors for you. These investors are not you are me, they are usually institutional investors with enough money to plop down millions of dollars worth of shares. They get the initial allotment of shares and then on the first day of trading these are the shares that go up for sale for buyers such as you or me.

But why would a company go public?

This is why it’s best to explain IPOs in the context of a company actually doing it. IPOs are not just a way for initial investors to exit the company, they’re also a way to raise money to continue the company’s operations. Tesla has been bleeding cash from the very beginning. Its founder made his millions selling PayPal to eBay. And he’s thrown many millions back into Tesla to keep it alive. He’s learned why the auto business is second only airlines in the “industries only a idiot would start a company in” category. Through himself and other investors, they financed the development and production of their first car, the sexy Tesla Roadster (pictured above). It starts at a few ticks over $100k. But the Tesla team knows that in order to put their all electric car company on the map they need a car that more favors the masses. So they designed the Tesla Model S (pictured below).

But getting this car to the masses is going to take some serious development money. And even though they’ve gotten some investments from a couple of car companies, and a nice chunk of cash from the government, they don’t have enough. So this is where the IPO comes in. It allows Tesla to raise cash from people that they don’t have to pay back. The stock could go to $0 and they go bankrupt. It’s unlikely, but it could happen. IPOs are great ways to raise cash.

There are other reasons for doing the IPO as well. It’s kind of a coming out party. It gets you a lot of press, and you now have to power spread out over many more investors and the CEO is able to maintain some extra level of control (sometimes). In this case the CEO is actually going through a divorce as well. He needs to cash in some of his Tesla stock to pay the settlement no doubt.

There are some concluding questions I’d like to answer as well. How does the investment bank get paid? Their job is to drum up interest and the more interest there is the higher the share price will be. They get a cut of each sale. So if Tesla sells for $18 a share, maybe they take $2 of that. Spread that out over tens of millions of shares and you have a nice cut at the end of the day. Also, how does a stock perform in its first few days of IPO. There are a lot of articles on the web you can Google about this, but more times than not, the stock takes off in the first few days due to intense demand. But there are some studies that show after a few years it tends to fizzle out and stay flat. I’d recommend that individual investors stay away form IPOs because they are risky. Especially for a company like Tesla which has never turned a profit. Do what I do, buy IPO stocks through fantasy trading. I bought TSLA and it’s done good things for my fantasy portfolio.

So that’s an IPO, I want to take a minute and talk about Tesla though too. I’m really excited about this company. As I said before, it’s been a long time since an American car company has done an IPO. And to top it off it’s an all electric company named after the awesomest dude you’ve never heard of. If I had the money, I’d already own a Roadster and would be on the waiting list for a Model S when it goes on sale (in 2012 I think). I love when startup companies take on the big guys. I can’t wait for the day that electric cars are the norm.

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: banking, business, cars, investing