What exactly is an IPO?

What is an IPO?

When a young company, often one built on an innovative, even game-changing idea, reaches a certain size, they are in a sense in a precarious position. With more investment funding, they might be able to grow into a leader in their industry, but without it, they might lose all the gains they’ve made.

The most common solution to obtaining huge quantities of funding is to ask for it from a wide variety of sources, and the stock market is perfect for this. Hence, the young company – stock in which was until now privately owned by its founders, key staff members and the investors who provided the seed capital – announces its intention to “go public”. This means expanding the number of shares, and offering them for sale on the stock exchange: an Initial Public Offering.

Initiating an IPO

One of the major differences between companies that are privately owned, and those whose shares are traded on the stock exchange, is that the latter needs to disclose much more information about the state of their business. Remember Enron? They violated this rule, deceived investors, and got into a lot of trouble as a result. A company contemplating an IPO will generally publish a prospectus outlining their operations and level of profitability, presented in the most positive way possible in order to raise the initial price of their shares. A few other requirements apply, such as that the company must have a board of directors to oversee its management.

Reasons for an IPO

Aside from the obvious need for cash to finance expansion, publicly traded companies are seen as more stable due to the level of public and SEC scrutiny, so they can borrow money more easily. Having shares on the open market also offers the flexibility that this liquidity offers: a company can buy back its own shares, or offer additional shares to garner additional investment.

Is it Wise to Invest in an IPO?

The only honest answer is “sometimes”. Inexperienced investors should generally stay away, since a detailed understanding of the industry within which the company operates, as well as knowing how to read prospectus, is a basic requirement for determining what the shares are worth. The company offering these shares has no reason to undervalue them on the first day, and sometimes go over the top.

The dot-com boom of the 1990’s gave IPOs in general a bad name, as companies that weren’t profitable and had little actual chance of becoming so flocked to the NASDAQ. Their shares were snapped up by investors who had little understanding of what the digital economy was and what it would become, and many of them took a bath when the bubble collapsed.

In general, the first rule of investing applies: be careful with your money, do your homework, and never dive into something you don’t understand.

IPO Investing

1.) Select a company with experienced and strong brokers: If you ever decide to invest in an IPO, be careful to pitch your tent with strong underwriters; this is because top-notch brokers generally bring quality companies to public, although this does not mean they never bring under-performers. However, it is noteworthy that large underwriting firms might not allow first-timers to invest in an IPO, those who get in through them are often long-standing high-end investors.

2.) Do an adequate analysis of information contained in company prospectuses: This is very important to avoid getting your fingers burnt. By reading through a company’s prospectus, one could easily spot its weaknesses and potentials. Information about proposed uses of the funds to be raised via the IPO could also go a long way to influence the decision about a company. For instance, buying into a company raising funds to repay loans or buy founder equities will be a wrong decision, on the other hand, a company planning to invest in research and development and expansion would most likely be a good buy. Also, over-bloated and unrealistic figures from projected earnings are bad signs; therefore, look out for overly optimistic future earnings. It is good for a company to make an average promise and over-deliver than overpromising and under delivering.

3.) Consult other sources of information: Understandably, getting information about private companies to base investment decisions on could be a Herculean task. While most companies try to disclose all information about themselves in their prospectus, it would be apt not to base investment decisions solely on this. So, it becomes crucial to search the public domain and the Internet for information. Researching on industry performance, reading press statements and news about competitors could help paint a better picture.

4.) Avoid over-hyped stocks: The probability of not getting the shares of a company going public is very high unless you are a high-end investor. This is because brokers do reserve their IPO allocations for “special people.” There are chances you will be investing in leftovers after the viable stocks have been handpicked by the big spenders if you accept to buy into the ones being hyped by your stockbroker, so, take caution.

5.) Finally, never buy during lock-up periods, if insiders continue to hold on to stocks long after the expiration of the lock-up period, it is an indicator the company has great potentials and a sustainable future.

An Initial Public Offering (IPO) is an indicator that a company is transforming from being privately held to a public company. It involves offering the stocks of such companies to the public for the first time through institutional investors on a securities exchange. Due to the unique risks involve in buying into a newbie in the stock market, many investors shy away from putting their funds into the purchase of IPOs, while exercising this skepticism could be worth gold at the end, getting in on an IPO could result in great returns if the following steps are taken:

1.) Select a company with experienced and strong brokers: If you ever decide to invest in an IPO, be careful to pitch your tent with strong underwriters; this is because top-notch brokers generally bring quality companies to public, although this does not mean they never bring under-performers. However, it is noteworthy that large underwriting firms might not allow first-timers to invest in an IPO, those who get in through them are often long-standing high-end investors.

2.) Do an adequate analysis of information contained in company prospectuses: This is very important to avoid getting your fingers burnt. By reading through a company’s prospectus, one could easily spot its weaknesses and potentials. Information about proposed uses of the funds to be raised via the IPO could also go a long way to influence the decision about a company. For instance, buying into a company raising funds to repay loans or buy founder equities will be a wrong decision, on the other hand, a company planning to invest in research and development and expansion would most likely be a good buy. Also, over-bloated and unrealistic figures from projected earnings are bad signs; therefore, look out for overly optimistic future earnings. It is good for a company to make an average promise and over-deliver than overpromising and under delivering.

3.) Consult other sources of information: Understandably, getting information about private companies to base investment decisions on could be a Herculean task. While most companies try to disclose all information about themselves in their prospectus, it would be apt not to base investment decisions solely on this. So, it becomes crucial to search the public domain and the Internet for information. Researching on industry performance, reading press statements and news about competitors could help paint a better picture.

4.) Avoid over-hyped stocks: The probability of not getting the shares of a company going public is very high unless you are a high-end investor. This is because brokers do reserve their IPO allocations for “special people.” There are chances you will be investing in leftovers after the viable stocks have been handpicked by the big spenders if you accept to buy into the ones being hyped by your stockbroker, so, take caution.

5.) Finally, never buy during lock-up periods, if insiders continue to hold on to stocks long after the expiration of the lock-up period, it is an indicator the company has great potentials and a sustainable future.