Tim Hortons goes public.

Canadian investors spent the first few months of 2006 salivating over Tim Hortons. Not its donuts or coffee. No, this time we're talking about its initial stock offering. The first public share offering of the popular donut chain caused almost as much buzz in Canada as the stock market debut of the search engine Google back in 2004.

These first stock offerings are known as IPOs – Initial Public Offerings.

The frequency, variety and size of IPOs can serve as a telling barometer for investor interest in a particular company, sector or market.

The reaction to news of Google going public, for instance, reminded many people of the late 1990s when so many new tech companies did the same.

IPOs were a booming business during the latter years of the 1990s and into 2000.

In 2000 alone, 101 Canadian IPOs in various technology companies raised $6.8 billion.

On the Nasdaq exchange in the United States, IPOs in the late 1990s were like a guaranteed lottery win for investors. Back then, the stock price in the first day of trading often shot up much higher than the IPO price that had been selected by the lead underwriters.

At the height of the dot-com boom in 1999, the average first-day returns on IPOs were an astonishing 71.7 per cent. Translation: Buy $10,000 of a typical IPO and see it rise to $17,170 by the end of the first day of trading. Now, that's a boom.

The dot-com bust put an end to much of that IPO gold rush. But by 2003 and 2004, the IPO market had begun to recover. In Canada, many companies were jumping on the income trust bandwagon, converting from privately held firms to publicly traded ones to take advantage of better tax treatment and a public thirst for trusts.

But it wasn't just income trusts. In 2004, ING Canada – the country's largest property and casualty insurance company – went public with an IPO that raised almost a billion dollars.

And, of course, the Google IPO that year unmistakably signalled that big IPOs were back, albeit at a less frantic rate than before.

What is an IPO?

As the name suggests, an "Initial Public Offering" refers to a company offering its shares to the public for the first time and enabling the stock to be traded on a stock exchange. Sometimes referred to as "going public," a company will do this in order to raise money and profile. And sometimes an existing publicly traded company (like Wendy's International) will spin off a subsidiary (Tim Hortons) through an IPO.

IPOs are usually done by smaller companies. That's why the IPOs from such established giants as Google, ING Canada and Tim Hortons attract so much attention.

When investors buy shares through an IPO, the money goes directly to the company. When they buy shares by way of a trade on a stock exchange, the seller of the shares gets the money.

Why do an IPO?

There are several reasons. Often a private company is started using the founders' own money or funds raised from banks, family, friends or venture capitalists. Once the company is established, going public is a way for investors to get their own money back and to pay back the people who gave them the initial funding.

Also, becoming public puts a company in the spotlight, which can attract other companies that can evaluate it for potential mergers and acquisitions.

Sometimes, companies spin off parts of their enterprise with an IPO to unlock the value of that part of the company – value that the market may not be taking into account.

Finally, if a company creates new stock and sells it, the company keeps the money and can use it to invest in the growth of the business by building a new factory, for example, or exploring for gold.

How does an IPO work?

In an IPO, companies write a prospectus that outlines the nature of the business, profiles the principal executives and reveals the company's financial situation and its prospects. The prospectus includes a "use of proceeds," which details how the publicly raised money will be spent. This allows prospective shareholders to assess the risk of investing in the company.

The underwriters – one or more brokerage firms – remove all risk from the share issuer by guaranteeing a certain price for a certain number of shares.

The underwriters also handle the distribution of shares to the public. They do all this for a fee – usually about six or seven per cent of the value of the IPO. That's why brokerage firms and investment banks love the underwriting business. When they take part in an underwriting deal, it can be worth tens of millions of dollars.

The underwriters are the ones who, in consultation with the company, set the initial offering price of the IPO along with the size of the offering. The IPO price is an extremely difficult thing to get just right. Underprice the shares significantly and the company is deprived of money it could have received through the IPO. Overprice the shares and the underwriters risk being stuck with shares no one wants – at least, at the IPO price.

The ideal situation is to underprice the offering just slightly. The company will be happy because it got the bulk of what the market thought its shares were worth; the underwriting firm's clients will be happy because their investment in the IPO is worth a little more; the underwriter is happy because the firm stands to get more underwriting business in the future.

Are there disadvantages to an IPO?

The most obvious disadvantage of going public is that the company no longer has privacy – everything about its business and finances becomes public knowledge. Management has to answer to shareholders and analysts. And because there are many more owners, any financial gains will have to be shared among a larger group of people.

There's no turning back, at least not easily. And probably the worst-case scenario in going public is that the original entrepreneurs can lose control over the company.

For investors, the main risk in buying an IPO is that they are often investing in companies with no established track record. During the dot-com boom, some IPOs managed to attract millions from investors who just wanted a piece of what they figured would be a guaranteed money-maker. As many later found out, there was no guarantee.

How does an investor get a piece of an IPO?

Investors who are interested in IPOs should call up their brokers and ask to be notified of coming offerings. But investors should also be aware that some IPOs are "oversubscribed." That means that public interest in the offering is so great that the entire offering of shares could have been sold many times over. Underwriting brokerage firms usually dole out chunks of popular IPOs to their best clients. Sometimes, investors who ask for 1000 shares of an IPO will be allowed only a few hundred shares as the brokerage firm rations its shares.

If you miss out on the IPO, you'll have to buy shares in the market once trading begins. In the case of Google, for example, shares of the IPO were priced at $85 US each. But only those who got a piece of the IPO paid that. When Google shares actually began trading, the asking price was $100 US.

Be aware that some underwriters frown on investors flipping popular IPOs on that first day of public trading to take a quick profit. Those investors may find themselves shut out of future IPOs.