An IPO, or initial public offering, is the process by which a private company offers its shares to the public for the first time. Investing in IPOs can be a lucrative opportunity for investors who want to buy shares at a low price and sell them later at a higher price. However, investing in IPOs also involves some risks and challenges, such as limited information, high volatility, and allocation uncertainty. In this article, we will explain what IPOs are, how they work, and how you can invest in them successfully.
What are IPOs?
An IPO is a way for a private company to raise capital from the public by selling its shares on a stock exchange. A private company may decide to go public for various reasons, such as to expand its business, to pay off debts, to increase its visibility, or to reward its employees and shareholders.
An IPO typically involves several steps, such as:
- Choosing an underwriter: An underwriter is a financial institution, such as a bank or a brokerage firm, that helps the company prepare for the IPO, such as by conducting due diligence, setting the price range, and marketing the shares to potential investors.
- Filing a prospectus: A prospectus is a document that provides detailed information about the company, its business, its financial performance, its risks, and its plans for the future. The prospectus is filed with the relevant regulatory authority, such as the Securities and Exchange Commission (SEC) in the US, and is made available to the public.
- Roadshow: A roadshow is a series of presentations and meetings that the company and the underwriter conduct with institutional investors, such as mutual funds, hedge funds, and pension funds, to generate interest and demand for the shares.
- Pricing and allocation: Based on the feedback from the roadshow, the company and the underwriter determine the final price and the number of shares to be offered to the public. The underwriter also allocates the shares to the investors who placed orders, usually giving priority to the large institutional investors.
- Listing and trading: The shares are listed on a stock exchange, such as the New York Stock Exchange (NYSE) or the Nasdaq, and start trading on the first day of the IPO, also known as the listing day or the debut day. The price of the shares may fluctuate significantly on the first day, depending on the supply and demand, the market conditions, and the investor sentiment.
Why invest in IPOs?
Investing in IPOs can offer several benefits to investors, such as:
- Getting in early: Investing in IPOs allows investors to buy shares of a company at the earliest stage of its public life, before the shares are widely available to the general public. This can give investors an advantage over other investors who may buy the shares later at a higher price.
- Earning profits: Investing in IPOs can also generate profits for investors who sell their shares at a higher price than they bought them. Some IPOs may experience a significant price increase on the first day of trading, also known as a pop, which can result in a large return for the investors who bought the shares at the IPO price. For example, Airbnb, the online travel platform, went public in December 2020 at $68 per share, and closed its first day of trading at $144.71 per share, a 113% increase.
- Supporting innovation: Investing in IPOs can also support innovation and entrepreneurship, as investors can help fund the growth and development of new and emerging companies that offer novel products or services. For example, Snowflake, the cloud data platform, went public in September 2020 at $120 per share, and raised $3.4 billion, the largest software IPO ever. The company plans to use the proceeds to expand its global presence, invest in research and development, and acquire other businesses.
How to invest in IPOs?
Investing in IPOs can be challenging and risky, as investors need to overcome some obstacles and uncertainties, such as:
- Limited information: Unlike established public companies, private companies that go public do not have a long history of financial reporting and disclosure, and may not have a proven track record of profitability or growth. Therefore, investors may have limited information and data to evaluate the company and its prospects, and may rely on the information provided by the company and the underwriter, which may be biased or incomplete.
- High volatility: IPOs tend to be highly volatile, especially on the first day of trading, as the price of the shares may fluctuate significantly due to the supply and demand, the market conditions, and the investor sentiment. The price of the shares may also differ substantially from the IPO price, which is determined by the company and the underwriter, and may not reflect the true value of the company. Therefore, investors may face the risk of losing money if the price of the shares drops below the IPO price, or if they sell their shares at a lower price than they bought them.
- Allocation uncertainty: IPOs tend to be oversubscribed, meaning that the demand for the shares exceeds the supply. Therefore, investors may not be able to buy the shares at the IPO price, or may receive fewer shares than they ordered, as the underwriter allocates the shares to the investors who placed orders, usually giving priority to the large institutional investors. Therefore, investors may miss out on the opportunity to buy the shares at a low price, or may have to buy the shares later at a higher price on the secondary market.
To overcome these challenges and risks, investors need to follow some strategies and tips, such as:
- Do your research: Before investing in an IPO, investors should do their research and due diligence on the company and its business, such as by reading the prospectus, analyzing the financial statements, understanding the competitive landscape, and evaluating the growth potential and the risks. Investors should also compare the company with its peers and industry benchmarks, and assess the valuation and the pricing of the shares, to determine if the IPO is worth investing in.
- Choose a broker: To invest in an IPO, investors need to have a brokerage account with a broker that has access to the IPO. Not all brokers have access to all IPOs, as some brokers may have a relationship with the underwriter, and some brokers may have certain eligibility criteria, such as a minimum account balance or a minimum trading activity, to participate in an IPO. Therefore, investors should choose a broker that offers the IPO that they are interested in, and that meets their needs and preferences.
- Place an order: To invest in an IPO, investors need to place an order with their broker, indicating the number of shares that they want to buy, and the price range that they are willing to pay. Investors should be aware that placing an order does not guarantee that they will receive the shares, or that they will receive the number of shares that they ordered, as the underwriter allocates the shares to the investors who placed orders, usually giving priority to the large institutional investors. Therefore, investors should be prepared to receive fewer shares than they ordered, or no shares at all, depending on the demand and the allocation.
- Monitor the performance: After investing in an IPO, investors should monitor the performance of the shares, and decide when to sell or hold them, depending on their investment goals and risk tolerance. Investors should also be aware of the lock-up period, which is a period of time, usually between 90 and 180 days, during which the insiders and early investors of the company, such as the founders, the executives, and the employees, are not allowed to sell their shares. The lock-up period is intended to prevent a large sell-off of the shares that could depress the price and hurt the public investors. However, when the lock-up period expires, the insiders and early investors may sell their shares, which could increase the supply and lower the price of the shares. Therefore, investors should be cautious and vigilant around the lock-up expiration date, and adjust their strategy accordingly.
Conclusion
Investing in IPOs can be a rewarding opportunity for investors who want to buy shares of a company at the earliest stage of its public life, and sell them later at a higher price. However, investing in IPOs also involves some challenges and risks, such as limited information, high volatility, and allocation uncertainty. Therefore, investors need to do their research, choose a broker, place an order, and monitor the performance of the shares, and follow some strategies and tips to invest in IPOs successfully.