Pre-IPO Financing Vs. IPO Prices

When a private company first decides to sell securities to the general public, it's called an intial public offering. Before the IPO, the company tries to attract investors with pre-IPO shares. Generally, the company sells these shares to private equity firms or hedge funds, particularly if the stock is likely to be in high demand. Although buying the pre-IPO shares can get you in on the ground floor of a lucrative investment, they can also become worthless if the company that issues pre-IPO stock does not follow through with the IPO.

Typically, the companies participating in IPOs are young, small companies trying to raise capital to grow their businesses, but sometimes large, more established private companies also offer IPOs so the public can buy and sell their stock. Companies work with an investment bank or underwriting firm that specializes in IPOs. The underwriter helps them figure out the types of stock to offer, the optimum time to go to the market, and the initial offering price.

In advance of the IPO, the company issuing the stock for the IPO may offer pre-IPO shares to private investors. Primary buyers, such as hedge funds, have the resources to buy large stakes in the company and commit to hold the shares as a long-term investment. Also, the U.S. Securities and Exchange Commission advises private investors to do their due diligence, particularly if the shares are marketed to the general public through methods such as spam emails. According to the SEC, these offerings are "often fraudulent and illegal."

As the day for the IPO nears, the company and the underwriter determine the initial price of the stock shares. They base the price on the company, the expected demand for the shares, and current market conditions. This price almost always exceeds the pre-IPO price. Once the shares get listed on the stock exchange and trade publicly, the value is determined by supply and demand for the offering. The SEC notes how extremely high demand for "hot" stocks can outstrip the supply, causing prices to "rise dramatically in the first hours or days of trading," but says that the effect often doesn't last.

Two viewpoints exist on the best time to buy an IPO. Some investors refrain from buying the stock until they can analyze the performance of the company once it goes public for a while. Other investors seek to get in on the ground floor if they believe the stock has a high potential to increase in value. These investors attempt to purchase the IPO shares as early as possible.