The allure of an IPO can be intoxicating. A glitzy, new company is headed to the market for the first time, you get in on the ground floor, and suddenly you’re rich…right? In reality, IPOs are a bit more complicated, requiring research and understanding to make sure investing in them is the right choice.
From Private to Public, What is an IPO?
An initial public offering, or IPO, is the first time that shares of a company are offered for sale to tsofihe public. Before the IPO, the company is considered to be private. There may still be shareholders, but it is often a relatively small circle that may include founders, early employees, or even private investors such as venture capitalists.
Theoretically, outsiders can invest in a company while it’s private, but to do so means approaching the company directly. At this point, the company is not obligated to sell shares and can reject an investment offer.
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 Wrigley Confectionery, manufacturer of M&M’s, Milky Way, and Twix—that have famously remained in private hands.
Once an IPO occurs, company stock is listed on a stock exchange and is available for anyone to buy. At this point, companies can no longer choose who their investors are.
IPOs often occur with much fanfare. Companies whose stocks are listed on the New York Stock Exchange for the first time may be invited to celebrate in a ceremonial opening of the stock market on the day of their IPO. Often the company rings the opening bell that signals the start of the day’s trading.
Why Have an IPO?
Private companies enjoy a lot of benefits. Among the two largest benefits are the fact that companies can choose exactly who invests in them, and they don’t have to report to a large pool of investors. What’s more, they don’t have to report a lot of financial information to the Securities and Exchange Commission (SEC), which requires annual reports and auditing.
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. Consider the IPO of Chinese e-commerce company Alibaba, one of the largest IPOs ever.
Their initial public offering in 2014 raised a staggering $21.8 billion dollars . In its 2012 IPO, Facebook raised $16 billion dollars . Not every company can expect such a showing, yet the potential for a huge boost in capital can be enough to make many companies want to go public.
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.
Understanding 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.
If there is a lot of demand for the stock, the price can immediately jump well above the IPO price. And it’s also possible that prices can fall if there’s little demand. Not everyone has the ability to buy shares at the IPO price. To understand who does, let’s take a deeper look at how IPOs usually work.
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.
At this point, 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 investors who may want to sell right after the Day 1 pop.
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, that 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, when the public can finally buy it on an open exchange.
Companies don’t necessarily have to take this route to make an initial public offering. When Spotify went public in 2018, it skipped the underwriting process, offering shares at the same time that it directly listed them on the stock exchange. There was no underwriter involved.
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.
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. To do so, a brokerage account would have to be set up and the cash used to buy the stock would be deposited into the account.
Once the 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. This all is predicated on that brokerage firm having an allocation and willing to give you a piece, which might prove difficult. Some brokerage firms reserve these allocations for only the most valuable clients.
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 stock 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.
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Recently, we’ve seen direct purchases used in a creative way to help employees at ridesharing company Lyft buy IPO stocks. Sometimes companies grants stock options to employees before an IPO as a way to reward hard work and loyalty as the company got off its feet.
Stock options may also be used as part of a compensation package. However, the SEC prevents companies from giving stocks to contractors, which include Lyft drivers.
To get around these rules, the company granted some of its drivers a cash bonus with the option to purchase shares of the company at the IPO price. Driver’s who completed 10,000 rides with the service were given $1,000, while drivers who completed 20,000 rides got a $10,000 bonus. In this way, the company does not grant employees shares of the stock directly, and employees can even choose to keep the cash.
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, those underwriters are busy getting people excited for the moment the company hits the market. You may be tempted to jump in and buy shares immediately, but before you do, there are some things to consider.
• 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 before hand 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 underwriter: You may also want to take a look at who is underwriting the IPO. Is it a large investment bank who has successfully launched other companies?
• Similar companies: 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. For example, Lyft’s IPO was the first ride-sharing IPO, leaving investors with few clues as to how it would perform or how investors value similar companies.
• 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. For the average investor, it may be worth taking a wait-and-see perspective before buying.
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 .
Investing Beyond IPOs
For the average person, investing in an IPO is likely a once-in-a-while situation at most and should likely represent a small portion of an overall portfolio.
The reason behind this is that investing too heavily in a single stock opens you up to potential risk. If that stock experiences a downturn, then your portfolio can take a relatively large hit. And as mentioned, IPOs are unproven on the public market and could experience a fair amount of volatility.
Adding diversity to a portfolio can mitigate these risks. A diverse portfolio might contain a mix of different assets, including stocks and bonds from various sectors.
Investors may choose to build a diverse portfolio by purchasing funds—such as mutual funds, exchange-traded funds, and index funds—that hold a diverse basket of stocks. Investors can build portfolios themselves with self directed investments, or through an automated investment service that creates a portfolio for them based on their goals and investment needs.
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