IPOs, or initial public offerings, are when a private company’s stock is sold to the public for the first time. They got a touch crazy during the dotcom frenzy days of the 1990s. Back then, investors could put their money into practically any IPO and almost always expect to make a profit—at least initially. Those that had the wisdom to get in and out of these businesses made investing appear simple. Unfortunately, many freshly public firms, such as VA Linux and theGlobe.com, saw massive first-day gains but ultimately disappointed investors.
The tech bubble eventually burst, and the IPO market reverted to normalcy. In other words, investors could no longer expect double- and triple-digit gains from stock flipping in the early days of tech IPOs.
There is money to be earned in IPOs again these days, but the focus has moved. Rather than aiming to profit from a stock’s first rally, investors are more likely to examine the stock’s long-term possibilities.
Taking part in an initial public offering (IPO)
To participate in an IPO, you must first locate a company that is set to go public. This is done by looking through the Securities and Exchange Commission’s S-1 paperwork (SEC).
An investor must register with a brokerage firm in order to participate in an IPO. Companies that issue initial public offerings (IPOs) contact brokerage firms, who then notify investors.
Before participating in an IPO, most brokerage firms require that investors meet certain criteria. Some IPOs may restrict participation to investors having a specific amount of money in their brokerage accounts or a certain number of transactions. If you qualify, the firm will normally ask you to sign up for IPO notification services so that you can be notified when new offerings that meet your investment profile become available.
Here are five things to bear in mind if you decide to invest in an IPO:
1. Conduct in-depth research for objective results
It’s difficult to find information about companies that are about to go public. Private corporations, unlike most publicly traded companies, do not normally have swarms of analysts following them about, looking for flaws in their corporate armour. Remember that, while most firms try to provide all relevant information in their prospectus, it is still authored by them and not by an independent third party.
Look up information about the company and its competitors, financing, previous press releases, and the industry’s overall health on the internet. Even if solid information is hard to come by, understanding as much as you can about the organisation is an important step in making a prudent investment.
Your study, on the other hand, may reveal that a company’s prospects are exaggerated, and that passing on the investment opportunity is the best option.
2. Choose a firm with experienced brokers.
Choose a firm with a reputable underwriter. We’re not arguing that the big investment banks never make bad investments public, but quality brokerages are more likely to be associated with quality in general. When dealing with smaller brokerages, be particularly cautious because they may be eager to underwrite any company. For example, Goldman Sachs (GS) can afford to be much pickier about the companies it underwrites because of its reputation than a much smaller, relatively unknown underwriter.
One advantage of boutique brokers is that, due to their smaller customer base, they make it easier for individual investors to purchase pre-IPO shares—though, as discussed below, this could also be a red flag. Be warned that most large brokerage houses will not enable you to invest in an IPO as your first investment. Individual investors are usually only allowed to participate in IPOs if they are long-term, established, and frequently high-net-worth customers.
3. Always read the prospectus before making a decision.
We’ve already stated that you shouldn’t place your entire trust on a prospectus, but you should always read it. The prospectus, which can be obtained from the broker in charge of bringing the firm public, spells out the subject’s risks and prospects, as well as the intended uses for the funds raised through the IPO.
If the funds are being used to repay loans or purchase shares from founders or private investors, for example, skipping the IPO may be worthwhile. This isn’t a good indicator, as it means the corporation won’t be able to repay its debts without issuing stock. In general, money spent on research, marketing, or expanding into new markets shows a far more positive picture.
Furthermore, one of the most important things to look for in a prospectus is an unduly rosy future earnings outlook. Those seeking for market success frequently make the error of over-promising and under-delivering, so it’s critical to analyse predicted accounting data carefully.
4. Exercise caution.
In the IPO market, scepticism is a beneficial trait to have. As previously said, there is always a great deal of uncertainty around initial public offerings, owing to a lack of available information. As a result, you should always proceed with caution when approaching them.
This is especially true if your broker suggests an IPO. When this happens, it usually means that the majority of institutions and money managers have graciously declined the underwriter’s offer to sell the shares to them. Individual investors are likely to get the bottom feed in this circumstance, the scraps that the “big money” didn’t want. If your broker is adamant about a certain offering, there’s probably a reason for the large quantity of available shares.
This should also serve as a reminder of another essential point: acquiring shares in a good firm poised to go public is tough for the average investor.
Brokers have a propensity of reserving IPO allocations for their most favourite clients, so unless you’re a high roller, you’re unlikely to get in.
5. Think about waiting till the lock-up period is over.
The lock-up period is a legally binding contract between the underwriters and business insiders that prevents investors from selling any shares of stock for a set period of time, usually three to 24 months.
Take Jim Cramer of TheStreet, previously TheStreet.com, and the CNBC show “Mad Money,” for example. His fortune on paper—in TheStreet.com shares alone—was in the tens of millions of dollars at the peak of TheStreet.com’s stock price.
Brokers have a habit of reserving IPO allocations for their most loyal customers, so you’re unlikely to get in unless you’re a big roller.
Final Thoughts
Successful firms go public on a regular basis, but sorting through the riffraff to uncover the ones with the most promise is no easy process. That isn’t to argue that all initial public offerings (IPOs) should be avoided. The companies in question have rewarded some investors who purchased stock at the IPO price handsomely.
Keep in mind that when it comes to the IPO market, sceptics with their fingers on the pulse are more likely to see their investments do well than those who are trusting and uninformed.
