Investing in Initial Public Offerings (IPOs)
Have you used apps like Uber, Lyft, Pinterest, Snap? At your workplace, have you used messaging apps like Slack or Zoom Video? In fact, all the companies I mentioned above are publicly traded companies on the US Stock Markets. Yes, you can invest in these companies when they announce that they will start trading publicly through an Initial Public Offering (IPO).
In this article, I will discuss what an IPO is and what to look for before investing in it. I will also explain how to buy shares of an IPO and what are the risks involved as IPOs need to be evaluated differently than a well-established publicly traded blue-chip company. Finally, I will also recommend a low-cost alternative to invest in IPOs through Exchange Traded Funds (ETFs).
Let’s get started.
What is an IPO?
IPO stands for Initial Public Offering. It is the first time when a company sells stock in publicly traded markets, often called as “going public”. Before an IPO, a company is private where investors are usually the company’s founders, venture capitalists, private equity firms or other professional investors. Once a company goes public, any investor with access to public markets can buy shares of IPOs just like any other company stock.
Why Do Companies Go Public?
Privately owned companies can go public for a number of reasons such as raising capital to grow the business, increase shareholder value, provide liquidity to investors and shareholders, and to use the stock as currency for mergers and acquisitions. IPO can also be a way for a company to lure talent they can’t afford to attract with salary alone.
Being a publicly traded company also shows that a company has been able to meet the federal regulations required. This helps in building confidence among potential investors.
What To Look for in a Company’s IPO?
IPOs can be risky investments and depend on the investor’s financial situation and risk tolerance. You can still make a ton of money by investing in IPOs by taking a long term view.
Following steps can be used as a guideline when you are considering investing in IPOs:
Doing Objective Research on the Company
Private companies do not have many analysts following them. They are not under as much scrutiny as the public ones. They usually disclose all information in the prospectus which is written by the seller and not an objective outsider.
Search for information on the company and its competitors, financing, past press releases, as well as overall industry’s health. If you find that the company’s outlook is inflated, then the best thing to do is pass.
“You want to be a harsh grader and find any flimsiest reason to pass on the stock.” — Mohnish Pabrai
Pick a Company with Strong Influential Brokers
Try to select a company that has a strong underwriter. Underwriters are investment banks that agree to purchase shares from the company and then sell them to their public market clients during an IPO.
For an IPO to succeed, companies need to make sure that they choose the right underwriter, the one which has had a history of successful IPOs. Be wary of smaller brokerages, some of whom will underwrite just about any company.
Always Read the Company’s Prospectus And Form S-1
A prospectus outlines the company’s risks, opportunities and what the money raised in the IPO will be used for.
If the money is going to pay off debt or buy equity from the founders or private investors, it is a red flag. It means the company can’t afford to pay off its loans without issuing stock. Money that will be used for research and development, marketing or expanding the business is a good sign.
Additionally, you can get more insights into how the company works or how the stock is valued by looking at the massive registration document required by the Securities and Exchange Commission (SEC) for all new securities in the United States.
Known as Form S-1, the offering document must contain specific information for investors, including financial information, the business model, risk factors and information about the industry. This document can be found on the SEC’s website, and it is normally loaded with caveats and disclaimers.
Due to a lack of information, IPOs are uncertain. If a broker recommends an IPO, use extra caution.
It’s an indicator that most institutions and money managers have passed on the underwriter’s attempt to sell the stock which means regular investors are getting the crumbs the big players didn’t want.
Wait till the Lock-Up Period Ends
The lock-up period is a legally binding contract (3 to 24 months) between the underwriters and insiders of the company prohibiting them from selling any shares of stock for a specified period.
When lock-ups expire, those parties can sell their stock. If the insiders hold onto the stock even after they can sell it, it may indicate a good buy for you too.
Consider asking the following questions to further reduce your risk:
- What helps the company keep its competitors at bay? Unique product pipeline, patents, trademarks, company’s management running the business? You want to look for things that would prevent another company from coming in and doing the same thing better, cheaper and more efficiently.
- Does the company have a sound business model and finances to support the model? Will they be wiped out through technological advances or lack of capital?
- Can you stomach a 50% drop in stock price due to market sell-off? Do you have the mental make up to hold onto the stock if you believe the company’s long-term prospects remain positive?
- How much stock is owned by insiders or institutional owners? Key venture capitalists and institutions who invested in the company in the very beginning play a vital role in controlling the business.
“Price is what you pay. Value is what you get.”
How To Invest in an IPO?
Okay, you have done your due diligence and found an exciting IPO you want to get in. How can you do it?
- To participate in an IPO, you have to be registered with a brokerage firm. The company informs the firm who notify you. Most firms will not allow your first investment with them to be an IPO.
- Most firms require you to meet some criteria before they can participate in an IPO. They might require a certain amount of money to be in the account or that an investor has made a certain number of transactions.
Note: You cannot invest in an IPO using your money in a margin account.
- Once qualified, the firm typically has you sign up for notifications that alert you to new IPOs that meet your investment profile.
- Even if you manage to clear all these hurdles, you might still be on the outside looking in. Brokers tend to save their IPO allocations for “preferred” clients, essentially clients having large amounts of money. So unless that describes you, you might not get a shot.
- Finally, as soon as the underwriting bank sets the price and it starts trading on the exchange, you can start buying IPO stock just like any other publicly traded stock.
Low-Cost Alternative Through ETFs
An alternative to buying the stock directly may be investing in one of the exchange-traded funds (ETFs) that invest in IPOs.
The Invesco Global Listed Private Equity ETF (NYSE: PSP) invests in the stocks of 61 different VC firms. This ETF is the best way to invest in these companies while they’re still private.
And then, as they become public, you can get a head start in investing in them by buying the Renaissance IPO ETF (NYSE: IPO).
IPOs can be risky and buying IPO stocks requires a lot of homework.
Even for those who are able to get in early, IPOs may not be a sure bet. So you should consider new companies carefully. It is wise to limit your position size on any individual stock by investing in a portfolio of equal-weighted IPO stocks.
Remember what Warren Buffett says:
“Rule 1: Never lose money.
Rule 2: Never forget rule 1.”
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Other Investing Articles by me
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- Momentum Investing: Be Like The Secretariat: https://medium.com/swlh/momentum-investing-be-like-the-secretariat-5d27521ba10
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- Fundamental Analysis Using Company’s Balance Sheet:https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-companys-balance-sheet-153531d98f8b
- Fundamental Analysis Using Free Cash Flow Statement:https://email@example.com/stock-investing-fundamental-analysis-using-free-cash-flow-statement-454beaa7f00
The content in the above article is for information and educational purposes only. I am not a licensed securities dealer or financial advisor. The views here are solely my own and should not be considered or used for investment advice. Also, I have no business relationship with any company whose stock or ETF is mentioned in this article. Please consider the risk involved and your personal financial situation before investing or seek a duly licensed finance professional for investment advice.
Amrut is a Full Stack Software Engineer who is passionate about designing and developing web and mobile applications. He likes to write about technology, coding, investing, trading, finance, and economics. In his free time, Amrut likes to understand business models of publicly traded companies and analyze their financial statements. He strongly believes in adding value to people’s lives through quality work and empower people to take control of their personal finances.