An IPO – or initial public offering – is an event in which a corporation begins selling equity investment instruments (or stock) on the public market. A company can exist as a corporation with stockholders prior to an IPO, but such a company is “privately owned”, with its stockholders usually consisting of a small number of early investors. When IPOs occur, they can enrich both the original shareholders and the early investors because they can quickly result in a significant climb in stock value on the public market. However, not all IPOs are created equal, and some early investors do lose money by investing in IPOs. In fact, they tend to underperform other stocks. Before throwing cash into that hot new tech company, you should bear a number of things in mind first.
The Underwriting Agreement
When a company decides to “go public” – or issue an IPO – it almost always solicits the aid of one or more investment banks to underwrite the transaction. This is because offering stock on the public market is a significant job in itself. When investment banks help with an IPO in this way, they may engage in one of two types of deals with the corporation:
- A bought deal or firm commitment is when the investment bank buys – or agrees to buy – all of the IPO shares from the corporation and then sells them to the public. The investment bank makes a profit by marking up the sales price.
- A best efforts arrangement is when the investment bank takes a flat fee for its services and agrees to do everything it can to sell the stock to the public at a particular price without a markup.
The difference between these two types of deals may seem to be mere technicalities, but it can actually be vital in judging the potential value of stock in an IPO. This is because investment banks usually have more profit potential in a bought deal or firm commitment than through a best efforts deal – but they also undertake more risk. If a bank opts for a best efforts deal, it is because the bank has doubts that it will be able to sell all of the stock at the specified price. This doubt on the part of the investment bank is often a telltale sign that the stock may not perform well.
The Registration Statement
In preparation for its IPO, a company must file a registration statement with the Securities Exchange Commission (SEC). This statement is referred to as an S-1 for domestic corporations or as an F-1 for foreign corporations, and it must be available to the public for an IPO to go forward. It includes some of the most vital information regarding the company. For instance, in the prospectus – or first part – of the document, you can find out whether the underwriting agreement is being made on a “firm commitment” or “best efforts” basis. Other important pieces of information found in this document are things like financial statements. You can view the company's profits and losses, as well as information on the company's market, clients and management. The information found in the registration statement can be dense, but it is vital to judging the value of a potential IPO investment.
The Rise And Fall
Every now and then, companies with a lot of media exposure and fanfare issue IPOs, and the result is a scramble among investors to buy. This often results in a localized bubble that can cause stocks to climb briskly for days or weeks and then fall again. In such a situation, a particular stock may level off again somewhere above the original IPO price, but it may actually sink below the original price. For this reason, savvy IPO investors try to get in as soon as possible and then watch the stock prices closely over the next several days. They often make significant short-term profits by cashing out just as signs of an impending crash appear. While this is certainly a legitimate strategy – and often the most intelligent strategy – the ensuing crash may not necessarily doom your investment in the company. If it is a healthy company with a sound business plan, the long-term viability of your investment will often remain, resulting in growth of normal levels after the initial volatility.
Another way to make a successful investment in an IPO is by foregoing the mayhem of the first days and weeks of the stock being traded on the public market. This is often the best bet for investors looking to make a long-term investment. Instead of riding the rollercoaster, long-term investors try to buy the stock just after its crash, assuming that it will see more gradual, normal growth in the future. One benefit of waiting until after the crash to invest is that the price may be lower than the original asking price of the IPO.
In some cases, company founders intend to use an IPO as a means of cashing out on their investment. When this occurs, their intent to make as much profit as possible from the IPO may result in an inflated asking price. In such situations, early investors usually lose because the price quickly drops and does not recover for some time – if ever. To spot an overpriced stock, investigate the founders and find out what their post-IPO plans are. If a majority shareholder and manager intends to stay on as the manager of the company, this tends to bespeak a certain level of solidarity and reliability. However, if he or she intends to move on to other things, this may be a sign of an inflated asking price.
When considering an investment in an upcoming IPO, the bottom line is that you must do thorough research if you intend to receive a considerable return on that investment. If you feel that you are not qualified to make that kind of judgment, or if the information in the registration statement is unintelligible to you, you may consider enlisting the services of a broker or personal finance specialist to help you with the decision.