Initial Public Offerings (IPOs) are the first time a company sells its stock to the public. Sometimes IPOs are associated with huge first-day gains; other times, when the market is cold, they flop. It’s often difficult for an individual investor to realize the huge gains, since in most cases only institutional investors have access to the stock at the offering price. By the time the general public can trade the stock, most of its first-day gains have already been made. However, a savvy and informed investor should still watch the IPO market, because this is the first opportunity to buy these stocks.
Reasons for an IPO
When a privately held corporation needs to raise additional capital, it can either take on debt or sell partial ownership. If the corporation chooses to sell ownership to the public, it engages in an IPO. Corporations choose to “go public” instead of issuing debt securities for several reasons. The most common reason is that capital raised through an IPO does not have to be repaid, whereas debt securities such as bonds must be repaid with interest. Despite this apparent benefit, there are also many drawbacks to an IPO. A large drawback to going public is that the current owners of the privately held corporation lose a part of their ownership. Corporations weigh the costs and benefits of an IPO carefully before performing an IPO.
If a corporation decides that it is going to perform an IPO, it will first hire an investment bank to facilitate the sale of its shares to the public. This process is commonly called “underwriting”; the bank’s role as the underwriter varies according to the method of underwriting agreed upon, but its primary function remains the same.
In accordance with the Securities Act of 1933, the corporation will file a registration statement with the Securities and Exchange Commission (SEC). The registration statement must fully disclose all material information to the SEC, including a description of the corporation, detailed financial statements, biographical information on insiders, and the number of shares owned by each insider. After filing, the corporation must wait for the SEC to investigate the registration statement and approve of the full disclosure.
During this period while the SEC investigates the corporation’s filings, the underwriter will try to increase demand for the corporation’s stock. Many investment banks will print “tombstone” advertisements that offer “bare-bones” information to prospective investors. The underwriter will also issue a preliminary prospectus, or “red herring”, to potential investors. These red herrings include much of the information contained in the registration statement, but are incomplete and subject to change. An official summary of the corporation, or prospectus, must be issued either before or along with the actual stock offering.
After the SEC approves of the corporation’s full disclosure, the corporation and the underwriter decide on the price and date of the IPO; the IPO is then conducted on the determined date. IPOs are sometimes postponed or even withdrawn in poor market conditions.
The aftermarket performance of an IPO is how the stock price behaves after the day of its offering on the secondary market (such as the NYSE or the Nasdaq). Investors can use this information to judge the likelihood that an IPO in a specific industry or from a specific lead underwriter will perform well in the days (or months) following its offering. The first-day gains of some IPOs have made investors all too aware of the money to be had in IPO investing. Unfortunately, for the small individual investor, realizing those much-publicized gains is nearly impossible. The crux of the problem is that individual investors are just too small to get in on the IPO market before the jump. Those large first-day returns are made over the offering price of the stock, at which only large, institutional investors can buy in. The system is one of reciprocal back-scratching, in which the underwriters offer the shares first to the clients who have brought them the most business recently. By the time the average investor gets his hands on a hot IPO, it’s on the secondary market, and the stock’s price has already shot up.
Although it is difficult to get in on the ground floor of an IPO, there are still ways individual investors can make money on the IPO market. For one, full-service and online brokerages are increasingly offering IPO shares to their customers. Unfortunately, these shares tend to be reserved for clients with the largest balances (usually $100,000 and up), and are thus out of the reach of many investors. Furthermore, most brokerages will not allow investors to sell IPO shares within a certain time period (generally 60-90 days), which prevents any short-term gains.
The other, more-realistic way to profit from IPOs is to buy into some carefully chosen stocks after they’ve become available to the broad market. In a suitably-hot IPO, institutional investors will not get as many shares as they want before the stock becomes available on the broad market; thus, an individual investor can buy the stock as soon as its available, and count on the institutional investors to drive the price higher. And, of course, the stock may rise purely because the share price is undervalued. We should point out, though, that historically stocks tend to fall slightly in the first several months of trading, so it’s often best to not buy on the first day.
As with any investment, proper education and careful research are vital to profiting from IPOs. Research should include a measure of the risks involved with investing in an IPO. Business, financial, and market risk are several of the risks that should be included in the evaluation process. Researching business risk involves examining the business model of the corporation and the management team of the corporation. Researching financial risk involves examining the corporation’s financial statements, capital structure, and other financial data. Researching market risk involves examining the appeal of the corporation to current and future market conditions .
You should also inquire about the purpose of raising capital through an IPO. If the corporation were issuing an IPO just to get out of financial problems, is investing in this corporation a wise decision? Those previous problems could be indicative of other problems, such as weak management. Similarly, if the company was having an IPO just because the IPO market was hot and investors were currently paying too much for IPO shares, then you would want to think twice before buying. On the other hand, if the company has some smart plans for the money, then the IPO might be justified. The investor must thoroughly investigate all available information to obtain an objective view on an IPO.
A direct public offering (DPO), like the more traditional IPO, is a stock’s introduction to the stock market. The stock is offered to the public for the first time. Unlike an IPO, which utilizes an underwriter to sell shares to the public, DPO shares are purchased directly from the issuing company. Individual investors have limited opportunities to participate in IPOs, so DPOs give the average person a chance to invest in a public offering. However, because DPOs are typically low-profile, it can be difficult to research and locate these offerings. These are less common and more difficult to research than IPOs.