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You’ve probably heard of IPOs and the buzz about their great money-making potential. Being the first in on something new is always exciting, and the probability of huge wins is enticing. But what exactly is an IPO? Is it for you?
An Initial Public Offering (IPO) is when a company transitions its business model from private to public by offering shares to public investors for the first time. The process is often referred to as going public.
Just the Nuggets
- Companies go public to achieve their long-term goals.
- IPO represents the first time that the shares are available on a public stock exchange.
- Companies partner with underwriters during the entire transition process.
- The shares can be purchased through the underwriter or directly from the company.
- IPOs are a good investment when they’re associated with a reputable broker and you, as the investor, have conducted thorough research.
- There is a risk associated with IPOs; going public is a big change for any company.
Why a Company Goes Public
Companies on the cusp of expansion and large growth often decide to go public. To meet their long-term goals, additional capital is needed. The following key benefits lead these companies to change their business models:
- Public companies secure funds from shareholders and rely less on banks.
- Once public, the overall risk associated with the business is widely dispersed amongst shareholders (versus an owner or small group of private investors).
- Money raised from the IPO can help offload debt.
The transition is often an exit strategy for founders and early investors. By selling their portion of the business, they cash in. Some will remain tied to the business, while others won’t.
How a Company Goes Public
When a company intends to go public, they commonly partner with an investment bank (or broker). The investment bank underwrites a portion (or all) of the shares and is a partner through the entire transition.
The selection, for both parties, is key. The company must select a reputable underwriter whom they trust to walk them through the process and sell shares on their behalf. On the other hand, the underwriter must carefully select IPOs to represent. By taking on a portion (or all) of the shares, they are in fact buying into the company and taking on risk.
The company, underwriter, and SEC—along with a lawyer and CPA—make up the joint effort in moving the company to public trade.
The Launch Process
The company files an intent to be publicly traded with the US Securities and Exchange Commission (SEC). You can visit the SEC website and see a list of filings in progress. The filing process is rigorous, but the company benefits by having a seasoned underwriter on its side.
The underwriter buys a portion (or all) of the company shares to raise funds for the transition and other operating expenses. The underwriter, in turn, sells the shares.
The underwriter creates marketing materials for the IPO and measures demand. The level of interest is simply an estimate but is used to create an overall valuation for the company and to set the initial IPO share price.
The requirements set by the stock exchange are completed to officially list the IPO shares. Once listed, the company is officially publicly traded, and any investor may buy its shares.
In some cases, companies opt to list shares directly on the stock exchange without the use of an underwriting firm. A direct listing is when a company completes the filing process with the SEC and jumps right to completing the requirements set by the stock exchange to become publicly traded, without the use of an investment bank.
While the IPO shares associated with a direct listing are available to the public in the same manner through the stock exchange, they skip the step of raising capital by selling shares to underwriters. They also take on the risk and responsibility of completing the requirements set forth by the SEC and the stock exchange. They forgo the guidance of an underwriter, but in turn save the high cost associated with their services.
Shopify went public through a direct listing. While this route is atypical, it’s seen in cases where a company is already (or nearly) profitable and the additional capital is not required right off the bat. Most companies cannot afford to miss out on the marketing exposure, cash, and support that comes with partnering with an underwriter.
How to Buy IPOs
A key to be first in on IPOs is to remain in the know.
1. Make a list of potential companies
Start by looking into S-1 forms filed with the SEC. This tells you what companies are in the process of going public. Details about the company’s finances and intentions can be found on the S-1.
2. Check out the underwriters
If you’re interested in buying from the underwriter, you will need to establish an account and create rapport to make your interest and intentions known.
3. Do your research
You should have full confidence in the company’s position in the market, management, and financial standing.
- Review the track record of the company leaders.
- Determine if there’s a clear competitive advantage over the competition.
- Review revenue growth to assure they’ve set themselves up for future success.
Remember—underwriters have skin in the game, so they are also doing research. Strong underwriters theoretically bring on the strongest IPOs.
4. Read the prospectus
As an investor, it’s your job to understand the company risks, opportunities, and how the company will allocate funds. While some use the funds to support the expansion of infrastructure or technology, others set them aside to offload debt. How do these two scenarios sit with you as an investor? Only you can decide.
5. Purchase through the broker or directly from the company
Through the underwriting broker or investment bank
In most common underwriting agreements, the underwriter buys a portion (or all) of the shares from the company, assumes the risk, and sells the shares. This transaction provides a nice sum of cash for the company to support operations. The investment bank has skin in the game and partners with companies they believe will have financial success. This scenario creates a strong demand for IPOs from underwriters. These shares often fall into the hands of institutional investors.
Institutional investors are groups that pool money to afford large investments. Examples include insurance companies, banks, mutual funds, and pensions.
The underwriter wants to sell the stocks quickly and in large quantities while helping their clients succeed. IPO stock prices are known for rising just after the launch, much due to the hype and attention. This often means, IPO buyers can expect a quick return on their money.
In the investment world, individual investors are relatively poor in comparison to hedge funds, banks, or insurance companies who have massive buying power. This is why individuals rarely get a shot at buying IPO shares from the underwriter.
Through the public stock exchange
The traditional method to buy IPO shares is to purchase them through the stock exchange as you would for other stocks. When the shares are live, any investor may purchase them anytime.
Who Gets to Buy IPOs
The IPO represents the first time that the shares are sold through a public stock exchange such as Nasdaq or New York Stock Exchange (NYSE). Anyone can buy IPO shares.
Are IPOs a Good Investment?
The probability of a quick return is relatively high. With the hype, positive marketing, and spotlight on the company, the share price often rises just after the launch. When it comes to long-term investing, IPOs come with risk. Like anything new, the lack of history makes predicting the future difficult.
Here are some points to ponder:
- Transiting to public trade is a big change for any company.
- While an operationally and financially sound company can greatly benefit from the added capital, it’s far from guaranteed.
- Growing too fast or beyond the business’ core competencies can lead to the stock faceplanting over time.
- Be cautious. As a retail investor—an individual investing their own funds in an independent manner—if IPO shares are offered to you by an underwriter, it likely means the other big dogs ahead of you have passed on the opportunity. Remain cautious if you find yourself in this position.
When should you buy?
If you are encouraged by the research, trust the underwriter, and understand the market position. Despite the risk, if an IPO has a reputable underwriter and you’ve done your research to understand the business plan moving forward, then investing in IPOs is considered a good investment.
When is an IPO a bad investment?
- If an underwriter is making a hard sale, this should raise red flags. It means others have passed on the investment opportunity, likely for a good reason.
- If you are not well-versed in the company, then participating in an IPO is a bad financial move.
- Decisions made around IPO shares are not to be made on a whim or light-heartedly. While your gut is a contributing factor to any money decision, your decision to invest in IPOs should be made on facts and research, not on feelings alone.
- Immediate price hike. IPO stock prices often rise after their initial debut. If this is the case, investors are immediately in the green.
- Sense of pride. With the hype of IPOs, it’s exciting to get in on the front end of a growing business. A sense of pride can come with your IPO shares.
- Dramatic price decline. The honeymoon phase can pass quickly. While a bump in value is often expected right after launch, a lackluster performance can quickly follow. If your stock plunges, there is a chance it will not recover. Even the big dogs fall into this trend. Twitter, Snap, and Spotify are examples. Their stocks all fell and have struggled to reach their IPO prices.
- Lack of information. Public companies are required to share in-depth financial reporting details with investors. You may have to dig in to get your questions answered. For young companies, history simply doesn’t exist. Even the savviest investors don’t have all the answers when it comes to investing in IPOs.
- Required patience and experience. It may take investing in several IPOs to truly come out ahead. Promising plans can flounder on the open exchange, but one big winner can greatly outway any loss previously incurred. Just remember, not all IPOs are going to be the next Peloton or Beyond Meats (two IPOs that skyrocketed upon going public in 2019).
Patience is a virtue that often rewards long-term investors. You should be aware of the lock-up period—a period of time when inside investors (employees, management, early investors) are not allowed to sell their stocks. The time frame varies but is typically three to six months. The goal is not to flood the market with the sale of shares, which would in turn lower the stock price.
If the shareholders are—for the most part—holding on to their stocks after the lock-up period, this is a good indicator of the future health of the company. Buying shares in the open exchange in this scenario is encouraged. Although you’ll have missed the IPO frenzie, you’ll still be on the front end of expected long-term growth.
Frequently Asked Questions
When can I sell my shares?
You can sell your shares at virtually any time once the company hits a public exchange.
What about fees and taxes?
While you’re letting out a cha-ching, don’t forget the broker is, too. Commissions will be owed and taxes will have to be paid. While you should consult with an accountant, earnings from stocks owned for less than a year are taxed as regular income—which is not the same as long-term capital gains taxes.
What’s another way I can get in on an IPO?
An appealing option is to invest in mutual funds that invest in IPOs. These are typically large growth funds that get you a piece of the pie. You’ll still be on the front end of great growth potential while maintaining more balance in your investment.
So who’s next?
Whether or not you try to enter the world of IPOs, watching the launches is always exciting. 2020 has been filled with twists and turns, and the market has followed suit. While some pushed pause on any big change when the market turned in late Q1, the end of 2020 has several big names making the news.
- Vroom is a recent IPO that has performed just as investors had hoped.
- Instacart—the home delivery service for groceries—has seen tremendous growth, thanks to COVID-19. They need the trend of home delivery to keep going and to retain their new customers in order to continue their notable success.
- Airbnb, the giant in the vacation rental market, has made headlines for its expected IPO offering.
- Doordash, known for delivering your favorite fast food and restaurant dishes to your doorstep, is making the news as its IPO shares will be sold yet this month.
2020 will go down as a unique time in history. While the pandemic has hurt many companies, others have found unique opportunities amongst the circumstances. These specific companies who were already slated to go public will continue on their journey.
Maybe you’re just getting started, or you’re looking to branch out in your investing strategies. Now you’re armed with the ins and outs of IPO shares. Whether your goal is to jump in or just remain informed, staying on top of up and coming IPOs is always smart when looking for new investment opportunities.
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