The basic concept of an IPO can be compelling: a glitzy company heading to the market for the first time, giving investors an opportunity to become owners of its newly minted shares.
In reality, deciding whether to invest in IPOs is a bit more complicated. IPOs require investors to research a company’s financial history and understand how they might grow their business in the future.
Here’s a closer look at IPOs and what to know before buying them.
Private vs. Public Companies
An initial public offering, or IPO, is the first time that shares of a company are offered for sale to the public. Once an IPO occurs, company stock is listed on a stock exchange and is available for pretty much anyone to buy.
Before the IPO, the company is considered to be private. Private companies may still have shareholders, but it’s often a relatively small circle that may include founders, early employees, or even private investors such as venture capitalists.
Outsiders can invest in a company while it’s private, but doing so can be more cumbersome and involve bigger checks or investment vehicles like private-equity or mutual funds.
For the most part, companies that choose to remain private are small or medium-sized companies, though there are some large companies—such as Mars Inc., maker of M&M’s, Milky Way bars, and Skittles, as well as Koch Industries, the conglomerate owned by famous political donors, the Koch brothers—that have remained in private hands.
Recommended: Investing in Private Companies
Why Have an IPO?
Two benefits that private companies enjoy is getting to choose who invests in them and not having to report financial results to a large pool of investors. Once a company goes public, it falls under the regulations of the Securities and Exchange Commission (SEC), which requires quarterly earnings reports.
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However, companies may hit a ceiling when it comes to how much private capital they can raise, and an IPO can give them access to large sums that can help them continue growing.
If demand increases for shares, companies can issue more shares in a secondary offering. These can occur when a large stakeholder in the company sells their shares, which doesn’t dilute the existing pool of stocks available on the market. Or a company can create all new shares, which raises the overall number available and can result in a drop in share price.
IPOs also often occur with much fanfare, which can help generate publicity for the business. Companies whose stocks are listed on the New York Stock Exchange or Nasdaq may celebrate in a ceremonial bell ringing that signals the opening of stock trading on the day of their IPO. All this can lead to photographs and press coverage.
IPO Price vs. Opening Price
The IPO price is the price at which shares of a company are set before they are sold on a stock exchange. As soon as markets open and the stock is actively traded, that price begins to go up or down depending on consumer demand. This is the opening price, and it can change quickly.
Not everyone has the ability to buy shares at the IPO price. When a company wants to go public, they typically hire an underwriter—an investment bank—that structures the IPO and drums up interest among investors. The underwriter acquires shares of the company and sets a price for them based on how much money the company wants to raise and how much demand they think there is for the stock.
The underwriter will likely offer IPO shares to its institutional clients, and it may reserve some for other people close to the company. The company wants these initial shareholders to remain invested for the long-term and tries to avoid allocating to those who may want to sell right after a first-day pop in the share price.
That’s why most regular investors don’t have access to shares at the IPO price unless they have an in with the company or its underwriter. This is especially true for the largest, most high profile IPOs.
Investment banks go through this relatively complicated process in part to help them avoid some of the risks associated with a company going public for the first time. The bank will try to make sure that the IPO is oversubscribed, when there are more buyers lined up for the stock at the IPO price than there are actual shares. The bank is trying to drive up demand, and subsequently the offering price of the stock.
Alternative IPO Routes
Companies don’t necessarily have to take this route to have an IPO. In recent years, alternatives to the traditional IPO have become more popular.
When Spotify went public in 2018, it skipped the underwriting process, instead going through a “direct listing”–when it offered shares at the same time that it listed them on the stock exchange.
The company was able to do this in part because it didn’t need to raise a lot of capital and people already understood what Spotify does. In other words, they didn’t need an investment bank to explain how the company works to investors in order to get them on board with buying shares.
Another way companies have been going public is via SPACs, or special purpose acquisition companies. SPACs are shell companies that raise money through an IPO, then use those proceeds to find a private business to buy. The SPAC then merges with the private business, taking the company public through the process.
SPACs have become hot suddenly in recent years, because they offer a speedier route to going public. They’ve also become more popular since determining the private company valuation is often done through negotiations that are conducted behind closed doors–a process that’s less vulnerable to volatility in the market.
Recommended: How Do SPACs Work?
How Do You Invest in an IPO?
If you want to purchase shares of a stock in an IPO, you’ll most commonly have to go through a broker.
Once a brokerage account is set up, you can let your broker know electronically or over the phone how many shares of what stock you’d like to buy, and the broker will execute the trade for you, usually for a fee, although many online brokerages now offer zero commission trading.
Direct stock purchase plans (DSPPs) offer another way for individual investors to buy company stock without a broker. Shares purchased in this way may have lower fees and might even be cheaper to buy. A DSPP can also be a handy way for new investors to buy stocks for the first time as DSPPs offer low minimum deposits.
The SEC regulates DSPPs in the same way that it regulates stocks bought through a brokerage, so the risks to investors are the same no matter how they purchase the stock. DSPPs may be reserved for a special group of people who are close to the company.
Is it a Good Idea to Buy IPO Stocks?
There can be a lot of buzz and anticipation surrounding an IPO. And that makes sense—remember, it’s the job of the underwriters to get people excited for the company’s debut. You may be tempted to jump in and buy shares immediately, but there are some things to consider.
IPOs tend to be by new companies that haven’t been around for a while. That increases the likelihood that they’re not yet profitable yet, and consequently, the valuation set by the IPO share price may be too high.
During the dot-com bubble, many investors were burned by young, unprofitable Internet companies that went public and then crashed in the stock market. More recently, data from Dealogic showed that since 2010, around a quarter of U.S. IPOs have seen losses after their first day.
Recommended: Guide to Tech IPOs
What is an S-1? What Is a Prospectus?
IPOs can be hard to analyze: It’s difficult to learn much about a company going public for the first time. There’s not a lot of information floating around beforehand since when companies are private, they don’t really have to disclose any earnings with the SEC. During an IPO, you can look at two documents to get information about the company: Form S-1 and the red herring prospectus.
Companies must file a Form S-1 with the SEC to register a new security, or stock. If a would-be investor can wade through these hefty documents, they can find information about a company’s plans for the capital they raise in the IPO, details about their current business model, and information about their competition. It also includes details about the security itself, such as how it was priced and whether it will affect other securities that are already listed.
Similarly, the red herring document reveals information about how the company operates and its prospects. There is no information about pricing or the number of shares that will be issued. The name of this document comes from a disclaimer written in red on its cover that announces that information contained within isn’t set in stone.
The SEC will go through the document making sure that the information inside is correct and that it doesn’t make any statements that violate federal law. Consider reading this document carefully before you decide to invest in an IPO.
The Lock-up Period
Shortly after a company’s IPO there may be a period in which its stock price experiences a downturn as a result of the lock-up period ending.
The IPO lock-up period is a restriction placed upon investors who acquired company stock before it went public that keeps them from selling their shares for a certain period of time after the IPO. The lock-up period typically ranges from 90 to 180 days. It’s meant to prevent too many shares in the early days of the IPO from flooding the market and driving prices down.
However, once the period is over, it can be a bit of a free-for-all as early investors cash in on their stocks. It may be worth waiting for this period to pass before buying shares in a newly public company.
Ultimately, investors don’t really know what will happen when a stock goes public. Stock prices could skyrocket, but they could also plummet. If you have your heart set on investing in IPOs, you can find out about upcoming listings by taking a look at stock exchange websites. The Nasdaq has a list of upcoming IPOs on its IPO activity page, and the New York Stock Exchange maintains a list of expected deals on its IPO center .
Savvy investors may also try to look at companies like the IPO that have already gone public. Doing so can provide a sense of how the company will perform once shares are listed. However, there may be cases where there really aren’t any good comparisons.
And as mentioned, IPOs are unproven on the public market and could experience a fair amount of volatility.
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