There’s nothing like the debut of a new product to get investors’ adrenaline going — and that’s why IPOs are such a major stock market event.
IPO stands for initial public offering, and it’s the process of a private company going public. Depending on the company, an IPO can cause quite a buzz and draw attention from retail investors and financial experts alike.
Participating in an IPO may therefore be on your financial bucket list. But there is a lot more to it than choosing which one of your favorite companies to give your money to. IPO investing is a big gamble. In fact, the financial experts we spoke to recommend proceeding with caution — or refraining altogether.
Keep reading to learn how an IPO works, how you might be able to invest in one, whether it’s a good idea, and what the less risky alternatives are.
What Is an IPO and How Does it Work?
An IPO refers to the first time a company sells securities to the public. A company issuing an IPO is also known as “going public.” Companies often go public as a way to raise capital for continued growth.
The IPO process can be a lengthy one. First, companies hire investment banks to underwrite their IPO. The underwriters help the company determine the initial security price, buy the securities from the issuing company, and then sell the securities on behalf of the company. Most major IPOs don’t just involve one investment bank. In fact, some of the largest IPOs have had teams of many investment banks.
The next step in the IPO process is SEC Form S-1, which companies must file with the Securities and Exchange Commission. This form includes the company’s prospectus, which shares vital information about the company and the securities it plans to offer. In the S-1, the company also discloses what it plans to do with the proceeds of the IPO.
Once the company has filed its necessary SEC forms and has completed the preparation process with its underwriters, it can officially go public.
Is It a Good Idea to Buy IPO Stocks?
Investing in an IPO can seem like an exciting opportunity, especially when the company going public is one that has a lot of buzz around it. But there are serious risks, and even the most buzz-worthy company can perform poorly after an IPO.
“Take Facebook for example,” says Brian Seay, a CFA and the founding partner of The Capital Stewards. “The IPO price was $38 dollars. After the initial price spike to $45, the stock declined significantly the first day and closed the week around $26. Facebook eventually went on to trade in the low teens before recovering years later.”
Rather than investing during the IPO phase, you may decide to wait until the company has had a chance to prove itself in the stock market. Then you can buy the stocks in a secondary market with more confidence that your investment will perform.
“Typically speaking, I think it’s best to let a company come public and get a couple of earnings seasons under their belt before investing,” Katzen said. “This allows an investor to better understand the business, revenue, and earnings growth and how they are handling the public markets.”
According to the Securities and Exchange Commission, IPOs can be risky and speculative investments, and that’s exactly how you may want to treat them in your portfolio. You might consider adding IPO stock to your portfolio, but only after doing your research into the issuing company and by investing money that you can afford to lose.
Before buying IPO stock, be sure to read the company’s prospectus where you can learn all about their business model, financial history, and plans for the IPO proceeds.
This is why experts recommend investing in hundreds of stocks at once, rather than relying on one single company. Index funds do just that. This protects investors from any downturn in a single company’s fortunes.
Who Can Invest in an IPO?
Unlike some other investments, there are no regulations around who can invest in an IPO.
But while anyone can technically invest in an IPO, the opportunity is more likely to be available to certain investors. Being the first to invest in an IPO requires having a connection to the company or access to a broker who’s been allocated stock, according to Michelle Katzen, a CFP and managing director for HCR Wealth Advisors
Often, IPO investors are institutional investors such as mutual funds, pension funds, insurance companies, and more. They could also be high-net-worth retail investors who have a relationship with one of the underwriters or with a brokerage firm.
IPO Price vs. Opening Price
When you hear about IPOs, you may hear the phrases offering price and opening price.
The offering price of an IPO is the price at which the securities are initially issued to the initial institutional and high-net-worth investors who buy them from underwriters and select brokers.
Meanwhile, the opening price of a stock is the price at which the general public can buy the securities through a public exchange such as the Nasdaq.
Underwriters set a company’s offering price after extensive market research, but the opening price is set by supply and demand. Depending on the success of the IPO, the opening price may be higher or lower than the offering price.
Private Company vs. Public Company
A private company is one that doesn’t offer securities in a public market. Instead, it’s owned by private parties that could include its founders and other private investors.
There are some critical benefits to being a private company. First, private companies aren’t subject to the same reporting requirements as public companies. Not only must public companies file an S-1 when they go public, but they must also file regular financial statements and other public disclosures. Private companies aren’t subject to those requirements.
Private companies may still sell equity to investors — they simply do it in a different manner. These firms often rely on venture capital and private equity to raise the capital they need.
Why Companies Go Public
Many people consider “going public” to be a sign of a company’s success, but that’s not always the case. As we’ve discussed, private companies still have ways of raising capital. And many large and well-known companies never go public.
So why exactly do some companies choose to go public?
“The reasons companies are going public have changed dramatically over the last decade,” said Seay. “In the 1990s and early 2000s, companies went public to raise additional capital to grow their business.”
But according to Seay, companies can easily raise the capital they need through private means. Instead, companies today are more likely to go public either so the founders or early investors can sell their shares or to benefit from the public attention that an IPO brings.
How Do You Invest in an IPO?
There are generally two ways to invest in an IPO. As we mentioned, most individual investors don’t have access to IPO shares. As a result, your only option to participate may be to buy shares at the opening price in the secondary market. In this case, you aren’t technically buying them from the company. Instead, you’re buying them from another investor.
But if you do have a relationship with an investment bank or brokerage firm involved in the IPO, then you may have a chance to buy the stock at the offering price.
- Do your research. This step is important for any type of investment, but even more so with an IPO, since the company doesn’t have a proven track record in the stock market yet. You can read the company’s prospectus to learn about the business, its stock, and what it plans to do with the proceeds of the IPO.
- See if you’re eligible. Some major brokerage firms like TD Ameritrade and Fidelity may have access to IPO shares for their clients. Each brokerage firm has certain requirements that limit which investors can participate — you must usually have a large amount of assets under management.
- Request your shares. Once you’ve confirmed you’re eligible to buy IPO stocks, you can request shares by submitting an indication of interest (IOI). Your broker may require IOIs to be for a minimum number of shares, though you may not receive all of the shares you request.
- Confirm your order. In addition to submitting your IOI, you’ll still have to place a buy order just as you would for any securities purchase. The exact process for placing an IPO order may vary from one broker to the next.