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There’s nothing like the debut of a new product to get investors’ adrenaline going – which is why IPOs are such an important stock market event.
IPO stands for IPO, and it is the process by which a private company goes public. Depending on the company, an IPO can cause a stir and grab the attention of private investors and financial experts alike.
Participating in an IPO can therefore be on your financial bucket list. But there’s a lot more to it than choosing which of your favorite companies to give your money to. IPO investing is a big gamble. In fact, the financial experts we spoke to recommend proceeding with caution — or refraining from it altogether.
Keep reading to learn how an IPO works, how you could invest in it, if it’s a good idea and what the less risky alternatives are.
What is an IPO and how does it work?
An IPO refers to the first time a company sells securities to the public. A company issuing an IPO is also known as ‘going public’. Companies often go public as a way to raise capital for further growth.
The IPO process can take a long time. First, companies hire investment banks to insure their IPO. The underwriters help the company determine the initial security price, buy the securities from the issuing company, and then sell the securities on behalf of the company. Most major IPOs do not involve just one investment bank. Some of the largest IPOs have even had teams from many investment banks.
The next step in the IPO process is SEC Form S-1, which companies must file with the Securities and Exchange Commission. This form contains the company’s prospectus, which shares essential information about the company and the securities it plans to offer. In the S-1, the company also announces what it plans to do with the proceeds from the IPO.
Once the company has filed the necessary SEC forms and completed the preparatory process with its insurers, it can be officially disclosed.
Is it a good idea to buy IPO stocks?
Investing in an IPO can seem like an exciting opportunity, especially when the company going public is one that has a lot of buzz around it. But there are serious risks, and even the most buzz-worthy company can perform poorly after an IPO.
“Take Facebook, for example,” says Brian Seay, a CFA and the founding partner of The Capital Stewards† “The IPO price was $38 dollars. After its initial price spike to $45, the stock fell significantly on the first day, closing the week at around $26. Facebook eventually continued trading into the lows before recovering years later.
Instead of investing during the IPO phase, you may decide to wait until the company has had a chance to prove itself in the stock market. Then you can buy the shares on a secondary market with more confidence that your investment will perform.
“Normally, I think it’s best to let a company go public and have a few earnings seasons in the pocket before investing,” Katzen said. “This will give an investor a better understanding of the company, its revenue and earnings growth and how they interact with the public markets.”
According to the Securities and Exchange CommissionIPOs can be risky and speculative investments, which is exactly how you might want to treat them in your portfolio. You may consider adding IPO stocks to your portfolio, but only after researching the issuing company and investing money that you can afford to lose.
Before buying IPO stocks, read the company’s prospectus, where you can learn all about their business model, financial history, and plans for the IPO proceeds.
This is why experts recommend investing in hundreds of stocks at once, rather than relying on a single company. Index funds do just that. This protects investors from any downturn in a single company’s fortunes.
Who can invest in an IPO?
Unlike some other investments, there are no rules about who can invest in an IPO.
But while anyone can technically invest in an IPO, certain investors are more likely to get the chance. To be the first to invest in an IPO, you must have a connection with the company or access to a broker to whom shares are assigned, according to Michelle Katzena CFP and Managing Director of HCR Wealth Advisors
Often, IPO investors are institutional investors such as mutual funds, pension funds, insurance companies, and more. They can also be high net worth private investors who have a relationship with one of the insurers or with a brokerage firm.
IPO price vs opening price
When you hear about IPOs, you may hear the phrases offer price and opening price.
The offer price of an IPO is the price at which the securities are initially issued to the initial institutional and high net worth investors who purchase them from underwriters and select brokers.
Meanwhile, a stock’s opening price is the price at which the general public can buy the securities through a public exchange such as the Nasdaq.
Underwriters determine a company’s offer price after extensive market research, but the opening price is determined by supply and demand. Depending on the success of the IPO, the opening price may be higher or lower than the offer price.
Private Company vs. Public Company
A private company is a company that does not offer securities on a public market. Instead, it is owned by private parties, including the founders and other private investors.
There are some crucial advantages to being a private company. First, private companies are not subject to the same reporting requirements as public companies. Not only are public companies required to file an S-1 when they go public, but they must also file regular financial statements and other public disclosures. Private companies are not subject to those requirements.
Private companies can still sell stock to investors – they just do it a different way. These companies often rely on venture capital and private equity to raise the capital they need.
Why companies go public
Many people consider going public as a sign of a company’s success, but that’s not always the case. As we discussed, private companies still have ways of raising capital. And many large and well-known companies never go public.
So why exactly do some companies choose to go public?
“The reasons why companies go public have changed dramatically in the past decade,” Seay says. “In the 1990s and early 2000s, companies went public to raise additional capital to grow their businesses.”
But according to Seay, companies can easily raise the necessary capital with private funds. Instead, companies today are more likely to go public so that the founders or early investors can either sell their shares or take advantage of the public attention that an IPO brings.
How do you invest in an IPO?
There are generally two ways to invest in an IPO. As we mentioned, most individual investors do not have access to IPO stocks. As a result, your only option to participate may be to buy shares at the opening price on the secondary market. In this case, you are technically not buying them from the company. Instead, you buy them from another investor.
But if you have a relationship with an investment bank or brokerage firm involved in the IPO, then you may have a chance to buy the shares at the offer price.
Do your research. This step is important for any type of investment, but even more so with an IPO, as the company does not yet have a proven track record in the stock market. You can read the company’s prospectus to learn more about the company, its stock, and what it plans to do with the IPO proceeds.See if you qualify. Some major brokerage firms such as TD Ameritrade and Fidelity may have access to IPO shares for their clients. Every brokerage firm has certain requirements that limit which investors can participate – you usually need to have a large number of assets under management.Apply for your shares. Once you have confirmed that you are eligible to buy IPO shares, you can apply for shares by submitting an Indication of Interest (IOI). Your broker may require IOIs to be for a minimum number of shares, although you may not receive all the shares you request.Confirm your order. In addition to submitting your IOI, you still need to place a buy order, just as you would for any purchase of securities. The exact process for placing an IPO order may vary by broker.