Initial public offerings (IPOs) can be attractive investments if you can get them at the initial offering price, and the price takes off if the public has a lot of interest. But they can also result in substantial losses if the public believes the offering is overpriced.
Here's a guide to IPOs, how they work, where you can buy them and a risk summary.
What Is an IPO?
When a company is expanding rapidly and needs more capital to support the growth, it can make an initial public offering (IPO) to raise funds by selling shares of capital stock to the public. This process lets public investors buy shares in the company for the first time. Becoming a public company gives the company access to large amounts of capital.
A company's founders often use an IPO as a way to realize a profit from their initial investments. In other words, it is an opportunity for early investors to sell their shares and cash out their investments.
How IPOs Are Created
Companies use investment banks for financial advice on structuring the IPO, determining how many shares to offer, gauging market demand, marketing the IPO and setting an initial offering price for the opening. One of the investment banks will be designated the lead underwriter for the syndicate to handle the distribution of the new shares of capital stock.
The company will become a new public company with its shares traded on a stock exchange, like the New York Stock Exchange or the Nasdaq Stock Market.
For a company to make an IPO, it must first file a registration statement with the U.S. Securities and Exchange Commission (SEC). This document will contain a prospectus and additional information and exhibits that must be filed with the SEC. Some of this additional information may not be available to the public.
Read More: What Does NASDAQ Stand For?
What Is a Prospectus?
A prospectus describes the terms and conditions of the IPO. It contains details about the company's history, its operations, the terms of the IPO and other information that helps investors to make informed decisions.
The public can view the information in the prospectus by logging into the electronic data gathering, analysis and retrieval system (EDGAR) for the SEC. EDGAR also contains Investor Bulletins that provide information about investing in IPOs.
Risk factors: Management identifies the risks they feel could have a substantial effect on the company’s operations and performance and the resulting impact these risks could have on an investment in the securities being offered by the IPO.
Use of proceeds: Management describes what they plan to do with the money from the IPO. It could be to pay down existing debt or to purchase fixed assets to enter a new market.
Dividend policy: This section discusses the company's history of dividend payments and what its plans are to pay dividends to future shareholders.
Dilution: This discusses how the offering is a dilution of the selling shareholders’ stock.
Limited trading volume: The number of shares being traded immediately after the IPO may be limited and could affect the trading price of the new offering. Shares held by the company’s founders and other investors may not yet be available for trading because they are restricted and may be part of a lock-up agreement, meaning that they can't be sold for a certain amount of time, like 180 days.
Management’s discussion and analysis: Management discusses their view on the company’s financial condition and results of operations.
Market overhang: Sometimes the company has shares that are authorized and outstanding but will not be traded at the time of the IPO. This is known as market overhang. The market price of the IPO may decline if these previously restricted shares are suddenly made available for trading in the market. The company must disclose the number of shares that it expects selling shareholders to make available for trading without registration after the IPO.
Read More: Secondary Offering Process
Setting the IPO Price
The underwriter does a lot of work and analysis to determine a fair price for the shares. The analysis considers the current value of the company and the amount of potential future earnings that will be created with the funds from the offering. These figures are combined to come up with a total value that is divided by the number of shares the company plans to offer to come up with a fair IPO price per share.
However, the price calculated by the underwriter may not be accurate. The underwriter doesn't guarantee that the price is fair. While some IPOs create much excitement, remember the IPO for Facebook, that doesn't mean that it’s a good idea from an investment standpoint to buy shares at the opening of the IPO.
Read More: Why Do Companies Issue Warrants?
How Do I Invest in an IPO?
Buying stock in an IPO isn’t easy. You can't just call your broker and put in an order for a number of shares. You have to work with a broker that’s a member of the syndicate and is handling the orders for the IPO. The syndicate members have been allocated a certain number of shares that they can offer to their clients.
Even then, shares of an IPO are often only made available to those special customers who have substantial accounts with the broker. Sometimes, the best strategy for the retail investor is to wait and see where the price goes after the opening.
What Else Should I Consider?
The stock price from an IPO can be quite volatile over the first few months. Investors don't know how the company is going to perform with its new infusion of cash. It's better to have some patience and wait to see where the stock price is going to settle before making any investment decisions.
Even for well-known private companies that are going public, investing in an IPO is risky. Quite often, IPOs are offered by companies with short histories of operation, some with just a few years or even less, which makes it difficult to speculate on the company’s future success.
Further, the initial offering price of the IPO may be overvalued. The offering price established by the underwriters reflects their judgment on the value of the company and the demand of the public for the shares. Investors often think the offering price is too high and the share price plunges immediately after opening, meaning you could lose money right from the beginning.
The Office of Investor Education and Advocacy has more information on how to analyze the prospectus for an IPO to make wise investments decisions and avoid fraud.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.