Complete Guide: Investing in IPOs (2021)
You have IPO FOMO.
And it’s no mistake. They’re packaged as silver bullets that create overnight millionaires.
But, less than half of IPO investments have positive returns. So what’s the real reason for all the hype?
What exactly is an IPO? How can you make money? Are they good for public investors?
What is an IPO?
The Definition: IPO means Initial Public Offering, the first opportunity for investors to buy shares in a company publicly.
It is the process of taking a private company and trading it publicly on the stock market, allowing investors to buy and sell shares freely. The IPO itself is the first public sale of shares to investors.
At its core, an IPO is a huge sales drive that secures a great deal of capital for the company as it sells shares en masse.
What isn’t an IPO?
Is an IPO a once in a lifetime opportunity to invest in that company? No. Once a company goes public it will remain on the stock market, unless it is taken private or goes bankrupt, and you can choose to invest in it at any time once it is public.
If you don’t invest immediately you are not missing out.
It can quite often make more sense to wait as IPO stocks generally fluctuate a lot in their first months, meaning you can often secure a better price if you hold off for a while.
When you think of an early investor you might think of Jeff Bezos, who famously invested $250,000 into Google. Did Bezos invest in Google’s 2004 IPO? Surprisingly not, he privately invested $250,000 in 1998 long before Google went public. That private round investment would now be worth billions.
In the UK and Europe, IPOs are, on the whole, offered by established private companies that have already received a great deal of investment from venture capitalists, angel investors, and business insiders. In Canada and Australia, many new companies may choose to go public immediately as private funding is a less established market for funding. For these countries, friends & family rounds are commonplace initially, but subsequently being able to access more capital from investors becomes important.
While there is good money to be made, it will probably not be on the scale you may be hoping for or being sold. Excitable and ‘bullish’ promoters may talk about ‘5 baggers’ and ‘10 baggers’ - referring to the multiple of returns to be made - these are a rarity and definitely not the norm. Can you imagine a world where every new project delivered the returns being claimed by promoters? There would be financial chaos! With investing there is a healthy dose of reality needed. If it was that easy everyone would be doing it.
Who can buy IPO shares? Can retail investors invest?
Contrary to what you may have heard, the biggest IPOs are not for retail investors, they’re a party to which you, quite literally, are not invited to.
“Hot” IPOs are sold by investment banks to their clients, who may be hedge funds, banks, pension funds, and very occasionally the odd high-profile retail investor. But, unless you happen to be an investment bank client with a portfolio worth millions then you’re not going to get the invite.
UK investor platforms AJ Bell, Hargreaves Lansdown, and Interactive Investor found that retail investors were only given access to 7% of UK IPOs between 2017 and 2020. These will typically be the smaller IPOs that institutions would not have the mandate to invest in.
A simple reason for this is also efficiency. It is far easier to sell a million shares to 5 of your existing clients than to 1,000 retail investors. So when it comes to popular IPOs, the majority, if not all, of the shares will end up in the hands of institutional investors.
If it sounds unfair, that’s because it is.
For the vast majority of retail investors, the chance to invest in a recent IPO comes once it floats on a secondary market, like the NYSE or LSE, when it is publicly traded. Unfortunately, this means you don’t get the chance to buy at the IPO price, so you’ll typically pay more than the underwriter’s clients.
Smaller, lower profile IPOs may be offered to individual retail investors through brokerages, but the smaller the IPO the more likely the chance of failure, so the risks increase dramatically.
“Investors may be wise to remember the Groucho Marx quote: 'I refuse to join any club that would have me as a member" and refuse to buy any IPO that they can access.' "- Robert R. Johnson, Professor of Finance at Heider College of Business, Creighton University
Why Do Companies IPO?
The main reason a company releases an IPO is to obtain capital (money) in exchange for equity (ownership of shares) in a company, plain and simple.
In the UK and Europe, private businesses have a few options to secure additional financing, with bank loans, venture capital, angel investors being the most popular, however, all of these methods have limits though.
Bank loans require proof of steady revenue and ultimately come with the cost of interest. And both venture capitalists and angel investors will be expecting to see a return on their investment within a 2-3 year timeframe, typically by selling all, or most, of their shares once the company goes public.
When it comes to raising a large amount of capital in a short space of time, an IPO is probably the most effective option as it makes investing accessible to more people and therefore to a larger pool of capital.
Credit card giant, Visa Inc.’s 2008 IPO saw 406 million shares sell at $44 a piece, raising $17.9 billion in a single day.
It is unsurprising that just a year after the IPO, Visa launched its first global advertising campaign, and announced in its 2008 Annual Report plans to expand into Brazil, India, and Russia.
The primary advantage of such a major sale of shares is that a huge amount of capital becomes available for expansion, enabling them to grow their businesses far quicker than they could by solely relying on revenue.
An Exit for Investors
An IPO represents an opportunity for existing early investors, like venture capitalists, employees, management, and friends & family to liquidate some, or all, of their shares.
Just as an IPO is the first opportunity for the public to invest in the business, it also represents the chance for these early private round investors to make money from their show of confidence earlier in the business’ lifecycle.
Investors buying into the IPO may be restricted as to how soon they can sell their shares due to a clause called the lock-up period, which we will explain in more depth later on. The lock-up period range can be between 4-6 months. Although commonplace, it is not mandatory.
The reason for this is to protect the company from early selling. If these early stockholders are quick to sell all, or most, of their shares at the earliest opportunity it can be perceived as a negative signal to others and create negative momentum in the stock, which is why lockup periods are popular with management teams.
Companies sometimes elect to issue warrants with their share offer, eg: for each share sold the company issues a full warrant at a future market price. ie: the share price is set at today’s price, and the warrant is set a future higher price. This is a sweetner to the deal for investors. However, one of the problems is that some investors may choose to realise immediate gains by selling the shares for a small profit and then ‘ride’ the warrants should they ‘come into the money’. The impact on the company’s share price can be damaging in the short term, and in most cases it may not recover. So hold periods can reduce the immediate off loading of share until the company has had some time to prove itself to the market.
A secondary reason for an IPO offering is a by-product of the IPO itself, exposure.
From media frenzies to Twitter trends, IPOs generate headlines. For some companies, especially those which already have some media traction, an IPO can exceed even the most sophisticated marketing campaign.
On the 10th February 2021, the day after Bumble Inc. released its IPO, it was the second most searched term on Google in the US. While the IPO raised $2.2 billion, it came with the added bonus of exposing millions to the brand and it will continue to reap the benefits as reporting continues to cover its progress.
Even for companies with much smaller profiles, the exposure can be significant as the story is picked up by both investors and industry publications.
Exposure is unlikely to be the main reason for an IPO, but it is an added benefit that can propel a company into the public eye.
Why Don’t Companies IPO?
Money and media attention: IPOs sound fantastic. But that leaves the question, why don’t all companies IPO?
While there are many individual reasons for a company choosing to remain private, they roughly fall into three main categories:
Once a company goes public it and its Directors become accountable to its shareholders, taking discretionary power away from the company’s management and demanding a huge amount and time and effort to continually report to the market and shareholders
Both the shareholders and directors place a high importance on the share price as a means of valuing the efforts of the company, and the business fundamentals. That said, there are some companies who ‘play or game the market’ because their fundamentals are not as strong as they would wish, nor indeed ever capable of being so. For them momentum, perception and media attention is critical to driving the share price or value of a company. For some private companies, the management may either not want to give up this control or would prefer to operate without the added pressures from shareholders and the board of directors. Indeed, it is because private companies are so hard to value that some may choose to remain private and not be scrutinised.
A publicly traded company faces a higher degree of scrutiny from regulatory bodies like the SEC (Securities and Exchange Commission), requiring it to increase financial reporting to a level that management may be uncomfortable with. By remaining private they are not required to undergo third-party audits on a regular basis,nor release in-depth financial analysis. This may also help to shield advantageous business practices from competitors. Being public also has cost implications driven by the need for regular financial reporting, management time & compliance and constant communication to new stakeholders, all of which distracts from the actual running of the business.
Some private companies may either, not require additional investment, or are content with their existing financing options. For example, a company may have a very good relationship with its bank, providing a reliable source of credit, or it may be achieving steady profits from its current revenue. This is one of the most significant reasons for a company not to IPO, as it negates the main reason why it would. But for businesses not yet generating revenue this is problematic. In the case of mining where projects can take 10-15 years to get into production, and therefore revenue, remaining private requires deep pockets and patient private investors, typically family offices. Hence, going public is the most common form of funding for mining companies.
So it is all a trade off for the management.
The Pros and Cons of Investing in an IPO
This is the part you will have heard a hundred times over and is probably why you’re here: IPOs can generate huge returns for their investors.
"Investing in companies that have just gone public can be very lucrative. That’s especially the case when they operate in innovative industries. More often than not, the best financial results can be achieved when holding onto the investment long enough to see the full magnitude of business value growth." - Rebeca Sena, GetSpace.Digital
This is true and some of the most popular IPOs prove this:
Tesla: From the 29th June 2010 to its peak in early January 2021, Tesla shares increased in value by 5076%, turning a $1000 investment into shares worth over $50,000.
Facebook: From the 18th May 2012 to its peak in late August 2020, Facebook shares grew in value by 672%, taking a $1000 investment to $6720.
Visa: From the 19th March 2008 to its peak in late December 2020, Visa shares grew in value by almost 400%, turning a $1000 investment into shares worth $4,000.
However, these figures are somewhat misleading, while these IPOs did lead to enormous returns for investors, to see returns on that scale you would have had to wait about a decade. And, perhaps, more significantly, the vast majority of IPO stocks never achieve returns of this scale.
You’ve probably seen articles shouting “If You Had Invested X in X, This Is How Much It Would Be Worth Today” which can feel especially painful if you missed your chance to invest. However, these articles rely on hindsight bias, in reality, it is almost impossible to predict which IPOs will perform like this.
The worst thing you can do is torture yourself over missing a successful investment or invest in a company based on your fears of missing out. The absolute best protection against bad investments is research, and understanding both the industry and the business you are investing in.
“FOMO is among the worst investment strategies you can have. Why didn't you invest in Bitcoin when it was $1? Why didn't you buy Amazon stock 20 years ago? Let your investments be guided by sound principles and be proud of making consistent good returns, instead of worrying about missing home runs.” - Daniel Penzing, Chief Editor of Maze of our Lives
Ultimately, there is no advantage to investing in IPOs, beyond the potential for larger returns. IPO shares should be considered in exactly the same way that any company stock is considered - they are by no means a special type of stock, they’re just a new one. And new doesn’t mean better.
In fact, in most cases, shares in companies that have recently IPO’d are worse than their “boring”, established counterparts.
Most IPOs are not successful, if this is the one thing you take away from this guide then it will have been a worthwhile read. The overwhelming likelihood is that you will lose money on an IPO investment.
The research on IPOs speaks for itself:
- Verdad Capital found that the average IPO lost almost a third of its value within the first three years, rising to over 40% by the fourth year.
- Forbes reported that between 1975 and 2011 60% of IPOs resulted in negative returns for investors.
- The Warrington College of Business found that, since 2017, 80% of US IPOs had negative earnings, a level not seen since the Dot Com Boom in 2000.
If you’re looking at the broad statistics, then you should avoid IPOs every single time, Verdad Capital even argues that you’re better off investing in a company that is long past its prime, think BlackBerry.
However, there are ways to reduce risk and increase your chances of a good investment. Jay Ritter, a world-leading expert on IPOs highlighted 2 factors, in an interview with Goldman Sachs, that are more likely to lead to positive investment outcomes:
1. Size: Data on IPOs is often skewed by smaller companies (with less than $100 million in annual sales) that generally underperform, however, larger companies (over $100 million in annual sales) that IPO generally perform just as well as established publicly traded companies.
2. Sector: The technology sector, in particular, averages returns 28% higher than the market, according to Ritter. He also highlights that years in which IPOs typically perform well are due to a higher proportion of the IPOs being based in the technology or healthcare sectors. However, he does note that this gap is slowly closing.
IPOs typically underperform across the board and result in losses for investors, however, larger companies, especially in the tech and healthcare sectors, outperform the market and provide greater returns.
People love IPOs, they’re novel, they’re fun, and they’re exciting, but people love speculating about IPOs even more. The amount of tweets and articles that follow IPOs around is incredible and the frenzy they generate undoubtedly pulls in investors who have very little understanding of where they’re putting their money.
The absolute worst basis for investing would be taking the advice of “@ ‘insert company name here’ tothemoon ” on Twitter. The chances of you finding genuine solid research and consideration amongst tweets and articles laden with buzzwords is next to zero.
Becoming emotionally invested in an IPO, or any share for that matter is a one-way ticket to failure. Don’t invest in a company because everyone is talking about it, don’t invest in a company because you’re a fan, and don’t invest in a company just because it sounds cool. Invest in a company because you have done some solid research, you understand the market, and the business fundamentals are strong.
Sure, you might get lucky, but the chances of remaining lucky over the course of several investments are tiny. You’re setting yourself up for disappointment.
While the majority of IPOs are under-priced, be wary of IPOs with high share prices without the business fundamentals to back them up. A business may not be worthy of a high valuation and it is essential to remember that the higher the valuation, the more capital will be raised by the company, and the more money the underwriter will make.
Consider the financials of a company, its customer base, recent performance and competitors and then make a judgement as to whether it is really worth the price.
Overvalued IPOs tend to suffer brutal corrections at the hands of the market, and it’s the early investors who lose.
A good example would be Lyft which offered an IPO price of $72 in March 2019, by the following March the same share was worth just $21.27, a huge 70% loss. Two years after its IPO Lyft still hasn’t equalled the share prices it achieved in its first weeks.
Always assess the valuation of the company.
"IPOs tend to be overrated, and it is often prudent to wait after the IPO to get a better valuation of the company. If a company is a good investment, it will remain so even after the IPO. You will most likely get better value for your money buying the stock after the IPO." - Joe Flanagan, VelvetJobs
IPOs are notoriously affected by high levels of volatility, this happens as a balance is being struck between the initial valuation of the IPO and the amount investors are willing to pay.
Volatility is so common amongst IPO stocks that a specific kind of investor known as an IPO Flipper has emerged to take advantage of it, seeking to sell their shares quickly to make fast profits.
It can be worthwhile to wait out the initial volatility, particularly for an IPO that may be overvalued, to achieve a better share price for your investment.
For longer-term investors volatility should not be a cause for concern, as it will decrease with time.
The primary difference between a volatile IPO and one that is overvalued will be that the latter will experience a sustained and significant fall in value, making it very important for IPO investors to closely track the progress of their investments in the first few weeks.
"How comfortable are you with (most likely) initial volatility? Are you looking to make a quick buck or hold the asset long-term? These are worth asking yourself before getting swept by the IPO fever all the more if it's a blue-chip name.
There is a long-term growth bias amongst stocks but that’s often a multi-year window. Buying on the day of the launch is never a guarantee that the price will surge upwards and there have been plenty of examples where after an initial surge the price tumbled down significantly.
So if you’ve done your thorough research, have nerves of steel and all the ducks align in a row then sure go for it. If on the other hand, you just want in cause you know the company, use their products, and/or "because they’re cool" then you might be signing up for a bumpy ride so buyers beware." - Bart Turczynski, ResumeLab
Behind the Scenes of an IPO
This is what happens behind the scenes in an IPO (Initial Public Offering.)
This is the value pyramid where you've got founders who generally get in at $0.01, friends and family getting in at $0.05, private -which is industry insiders, brokers and letter writers – they come in at $0.15. Then you have the IPO where it gets handed out to the public at $0.50, and this is standard throughout the space.
A lot of people need to understand that if you're getting into something like this, the founders and friends & family literally have a good outcome... regardless of what happens.
The stock price can drop to 2/3rds of this and they're still making multi-bagger returns. It's also the amount of capital that the IPO investors are putting up. It's got a nice chart down the side with the amount of capital that has been invested for the amount of stock. The founders are putting up 2.5% of the capital and they're getting 43% of the stock, whereas the IPO investors are putting up 80% of their capital and getting 27% of stock.
As an average investor, you can easily become a bag holder if you don't know or trust who you're getting involved with. (A bag holder is a term that refers to somebody who holds a stock all the way down to zero when it becomes worthless.)
It's important to understand where you as an individual investor sit in this inverted pyramid. Many new investors to IPOs think they are getting in first (after all, it’s called an initial public offering), but as you can see, that's not really the case at all.
There are industry insiders, brokers, letter writers etc who get these discounted shares, and promote the stock... even if they know the asset is not a good investment... with an intention to pump the hype behind the stock and then dump the shares as soon as the 4 month lock-up period comes off. It's much better if a company has a longer hold period like 12-24 months for example, because it shows that they are serious.
Due Diligence: How to Decide Whether To Invest or Not
"IPOs can be a good investment if you understand the offered business model, founding team, risk management, fundamentals, capital structure together with how the collected funds will be invested. Most investors love trading IPOs because of their high potential reward without realizing the risks. However, no matter how much research an investor does, there are always chances things can go wrong. Given that enough research is made, and proper diversification measures are taken, an educated IPO investment may be a lucrative option to earn large returns in the market." - Altay Gursel, Metriculum
How to Read a Form S-1: The Prospectus
When it comes to IPOs the first and most important source of information is the company’s Prospectus, as it will give you a complete overview of the business, its financials, and its plans. The purpose of the Prospectus is to inform potential investors about the business so that they can make educated investment decisions.
IPO Prospectuses are freely available on the SEC website, and there are thousands of them, so there is no excuse for not doing your research.
Unfortunately, this is where, as an investor, you need to start putting some work in. Prospectuses are long, in-depth documents that are often confusing and daunting if you are unfamiliar with them.
Luckily for you, we’ve broken down the general layout of most Prospectuses, highlighting the key sections and how to tackle them.
It’s a good idea to read a Prospectus so you can become familiar with the layout, both Google and Facebook’s are strong examples as they keep it concise, for a more recent example there is Bumble’s which was released at the start of 2021, however it is rather long, topping 240 pages.
As you might expect this is an overview of the entire Prospectus and will give you a grasp of the business model, products/services, and selected financial data. If you were to only consider one section then this would be the one, however, it is lacking any real analysis and will only provide a surface-level understanding.
2. Risk Factors
Essential to gaining a balanced understanding of the business, covering the potential risks to investors and the success of the business. Many of these risks will be generic such as competition or brand image but there are also business-specific risks which are those that deserve special consideration.
For example, Facebook highlighted that Zynga, an online video games company and creator of the dreaded Farmville, was responsible for 12% of their revenue. Should their relationship with Zynga have collapsed then their business would’ve suffered.
Google’s prospectus mentions the inexperience of the management team and how they expected to encounter difficulties whilst trying to expand outside of the US.
The Risk Factors are particularly important to understand the vulnerabilities in the business model, and these issues should be considered when comparing the company to its competitors.
3. Use of Proceeds
Whilst generally rather vague this section covers how the company will use the capital generated by the IPO, typically emphasising expansion and business acquisitions. However, it can be useful in gauging the company’s priorities, such as repaying outstanding debts, interest, or taxes.
Bumble’s prospectus mentions their plans to use a portion of the proceeds to repay certain debts they had acquired. This tells you, as an investor, that not all of the money raised will be going into expansion, potentially limiting future growth on the back of the IPO.
4. Consolidated Financial Data
For investors, the financial data should be a key area of interest, no pun intended. Typically there will be data from the last 5 years of business, broken down into revenue, costs, and income.
However, the financial data may be limited to just 2 years if the company has an operating revenue of less than $1.07 billion designating it as an “Emerging Growth Company”. Bumble qualifies as this classification so its prospectus only contains financial data from 2018 and 2019.
This section is vital to understanding the financial trajectory of a company and its growth as you can track year-on-year changes. It can be useful to compare this financial performance with that of competitors to contextualise the information.
As with any investment the financial fundamentals are key to making educated decisions.
5. Management’s Discussion
This section follows on directly from the financial data and presents an opportunity for the company’s management to explain their financial performance and their business model. A great deal of emphasis is placed on the change in performance displayed by the financial data.
A key aspect of this discussion is that it provides context for the financial data, and how each year fits into an overall trajectory for the business. For example, a year with low income may have been a result of increased costs for expansion, rather than being indicative of poor business performance.
The Management Discussion is critical for gaining an understanding of the broader financial picture.
This is essentially a business pitch and will attempt to sell the conceptual basis of the company to you. It will vary depending upon the business model but it broadly focuses on the business, its products/services and customers.
Google’s prospectus for example is split into several sections addressing their three different customer bases, users, advertisers and websites. Before offering a broader overview of the services that they provide.
As an investor, this breakdown is particularly useful for understanding how a business differs from its competitors.
Finally, the management team, their backgrounds, qualifications, and ages. For an investor, understanding the business’s hierarchy and, more importantly, the levels of experience present amongst the executive officers and directors is essential. It will give you an indication as to how the company will perform in reality, not just on paper.
While a young, relatively inexperienced team isn’t certain to doom a company to failure, it is always reassuring to see that they are being supported by more experienced hands.
How Does a Company IPO?
"It is difficult to fully assess whether an IPO is good or bad prior to them going public. Until a company goes public, its financial and operational information may not be readily available. Like with most lending institutions, in order to assess one’s creditworthiness you need information about their credit history. Based on that information their creditworthiness can be assessed. Similarly, it might be best to wait until a company goes public so that you can have access to their financial statements, and over time you can better assess if it is worth the investment." - Rronniba Pemberton, Markitors
An IPO is a long and complicated process, involving lots of legal jargon and many, many meetings, so we’ve simplified the process to give you a grasp of just how a company transitions from private to public.
We’re also going to put you in the position of the business, which makes the process easier to understand.
The first step in taking your company public is getting a valuation. This is key to the IPO as it will inform the ultimate price that the shares are sold for. To get a valuation you need to approach an investment bank or regulated company, which underwrites the IPO and will facilitate the sale of the IPO shares. In most cases, this will be a group of investment banks, known as a syndicate.
The reputation of the underwriter is incredibly important:
“If a reputable broker is putting their name to the offer, then investors can obtain a degree of confidence that a finance person has given the offer some commercial consideration and is prepared to back it.” - Brandon Munro, CEO of Bannerman Resources Ltd
The investment bank, or underwriter, will work with your company to establish a reasonable valuation. Obviously, the higher the valuation, the more money the company will recieve. There is an incentive to aim high, however, overvaluation can be incredibly dangerous, causing share prices to plummet following the IPO should the business fundamentals not deliver what was promised. Once trust has been lost in this way many companies and Management Board find it hard to regain their reputation and recover. So best to be fairly priced from the start.
After announcing your intention to IPO, the valuation is the next newsworthy event as it will likely be the first time that a specific value has been attached to your business.
2. Sales Agreement
When the IPO is offered the underwriter will purchase the shares from the company and then sell them to their clients, this is where the underwriter makes their money, as they will issue the shares for a higher price than they bought them for. So, once both company and underwriter have agreed on a valuation, it’s negotiation time.
The difference between the two prices is known as the gross spread. For example, if the company sell values its shares at $75 million, and the underwriter then sells them to investors for $100 million, the difference is $25 million, equating to a gross spread of 25%. An exorbitant fee you’ll but is merely for the sake of keeping the math simple.
On average the gross spread will be between 4-7%, typically the greater the value of the business / the raise, the smaller the gross spread.
Why does the gross spread matter? As an investor, the gross spread can tell you a lot about the confidence of the underwriter. An alarmingly high gross spread indicates that the underwriter has less confidence in the success of the IPO and risk they attribute to it.
It is also important as it indicates the value of the share price, the lower the gross spread the better the value.
The next publicised step is registration, this is the paperwork-heavy element. To trade publicly a company needs to list on a stock exchange, like the New York Stock Exchange (NYSE), the London Stock Exchange (LSE) or Toronto Stock Exchange (TSX) where they will be regulated by the relevant financial authority such as the SEC for the US, the FCA (Financial Conduct Authority) in the UK and Investment Industry Regulatory Organization of Canada (IIROC) in Canada.
Regulation is an essential component of reigning in any potential misleading statements and behaviour from the company and is empowered with the ability to prosecute, fine and punish both the company and its Directors. For example, The SEC is responsible for ensuring the legitimacy of a business and the accuracy of the data it provides to investors.
To register with the SEC the company is required to fill out an S-1 Form which requires the company’s financial information, management structure, business model, the Exchange that the company is to be registered on, and a great deal more, we’ll cover all of this in the Prospectus section.
The S-1 contains 2 parts, the first part known as the Prospectus is freely available for anyone to read, the second part contains sensitive information only available to the SEC.
Once the company has filed your S-1 Form it can start trying to find investors.
Like with any sales drive, marketing is everything, it is now the time to convince people to invest in the business.
The primary method is the roadshow, which sounds like a lot more fun than it actually is. The roadshow involves presenting to various clients of the underwriter, in an attempt to persuade them to put in orders for stock. The presentation will cover a lot of the information in the Prospectus but will also enable potential investors to ask questions.
While, as retail investors, we won’t get invited to the roadshow, we will be exposed to the media drive. This is not controlled by the company releasing the IPO but comes as a result of announcements concerning the IPO, share price, and release date, people often consider this IPO hype. It is crucial for generating interest amongst private investors who will be able to purchase shares after the IPO.
5. The IPO
After being approved by the SEC and securing enough share orders the company can go ahead with the IPO.
After a date has been decided, the IPO has been approved by the SEC, and the price has been confirmed with the underwriter and investors then the IPO can be released.
The underwriters will purchase the IPO shares from the company which they will then sell on to their clients that have ordered stock. At the same time, the company will be floated on the exchange of your choice, which will enable existing investors and new IPO investors to trade their shares on the public market.
This is when retail investors can get involved as they are now able to buy the traded shares.
6. Lock-Up Period
The final part of an IPO, which generally lasts for 3-6 months after the IPO release, is the lock-up period. It’s an agreement that prevents early investors, like venture capitalists or employees, from selling their shares immediately following the IPO.
By preventing existing shareholders from selling for this period will protect the early performance of the stock, preventing the price from entering a downward spiral as early investors exit their positions.
When considering investing it is important to know when the lock-up will expire for 2 main reasons:
- The share price often falls immediately after the lock-up as investors exit, potentially making it a good time to buy-in.
- It is an indicator of investor confidence, if few shares are sold after the lock-up ends then it suggests that existing investors are confident that the company will continue to perform well and provide an even greater return on their investment.
What is the #1 mistake retail investors make with IPOs?
“Thinking that every IPO is going to be the next LinkedIn, Alphabet or Facebook.” - Azmi Özünlü, Financial Markets Trainer
“Buying the trend without understanding the business.” - Brandon Munro, CEO of Bannerman Resources Ltd
“Confusing a good product with a good investment...to be a good investment, the firm must have a sustainable business model.” - Robert R. Johnson, Professor of Finance at Heider College of Business, Creighton University
“Investing in too many IPOs without due diligence or discrimination.” - Vinod Mahendroo, Senior Executive, Investor in Public & Private Markets
“You shouldn't be investing because a company is having its IPO. You should only invest because you think the company is a great investment.” - Daniel Penzing, Chief Editor of Maze of our Lives
"Whether or not you consider IPOs a good investment depends on your definition of the term. If you equate 'good investment' with 'safe bet' or 'sure thing' then no. While some IPOs can result in handsome returns, the majority tend to underperform in the market. IPOs are a risk, and it is important to understand this fact when investing. Expecting to get rich off an IPO is a gamble, and you should conduct research, realistically weigh your odds, and make peace with the possibility of losing money before buying in. Basically, enjoy the ride, but do not put all your hope in cashing in on one good hunch." - Michael Alexis, Teambuilding
Should I Invest in an IPO?
IPOs can present a great opportunity to receive higher returns on your investments, but it is critical to understand that these instances are the exception and not the rule.
Most IPOs are not successful, but you can increase your chances of success by investing in larger, more established companies, and by picking strong sectors, like technology and healthcare.
Always read the prospectus, and read it cynically, it is written to make you want to invest and will always try to promote the strengths of the business over the weaknesses. The financial fundamentals and risk factors are your keys to contextualise and critique the arguments the company’s management will make.
Be wary of IPOs with high valuations but without strong business fundamentals to support them, be critical and ask questions when you review the prospectus.
Don’t believe the hype, do your research and properly consider the business’ outlook before investing.
“Those who do their homework diligently are rewarded by multiple stock appreciation on the heels of a property selected IPO” - Vladimir Rojankovski, Licensed International Financial Analyst (LIFA)
Be willing to take your time, let the hype die down and take advantage of share prices that may be lower than the IPO price. Facebook’s shares lost 50% of their value in the first 3 months of trading and General Motors shares lost 40% in the first year of trading, so sometimes it pays to wait.
IPOs, very simply, aren’t that special, they aren’t what the hype makes them out to be. Some of them can make excellent investment opportunities but these companies are in the minority. If you’re investing in an IPO just because it’s an IPO, chances are you’re making a mistake.
The safest way to invest in an IPO is to be as critical as possible, the purpose of an IPO is to sell shares, it is your responsibility as an investor to counter the hype with research, cynicism, and rationality.
How can I invest in IPOs?
Placing An Order
This involves placing an order for an amount of shares from one of the brokers or underwriters involved in the IPO. A specific amount of shares will be allotted to each broker involved, which they are then able to sell to their clients when the IPO is released.
Should you have an account with a broker involved in the IPO you may be able to place an order for some stock. Yet, for most IPOs only the largest clients, mostly institutional investors, will be given the opportunity to order shares.
You may be given the chance to place an order on smaller, lower profile IPOs, however, these investments are typically far riskier.
There is a growing movement to give retail investors better access to IPOs with platforms like PrimaryBid seeking to level the playing field, but at the moment your options are limited when it comes to placing orders.
The Secondary Market
After IPO day the shares will be freely available for trading on secondary markets, like the NYSE or LSE, fortunately, there is a huge range of options when it comes to buying shares after the IPO.
With the increasing accessibility of trading platforms, it has never been easier to invest in company shares. Popular platforms like eToro, IG, and Robinhood, all facilitate the purchasing of shares, including those of companies that have recently released an IPO.
Each trading platform is different and facilitates trades on different markets, for example, Robinhood currently supports US exchanges and offers access to 5,000 different stocks. By contrast, eToro offers access to over 2,000 stocks over the exchanges of 16 different countries.
Recent IPOs like AirBnB and Bumble are available for trading across both platforms. Provided that the company releasing the IPO has a reasonably high profile then it is likely that it will become available on a trading platform.
Finally, the traditional method of investing in company shares, should you have a broker you can easily place an order for shares of a recent IPO. However, for new retail investors interested in IPOs, trading platforms are the more popular choice.
What to do once you’re invested in IPOs
1. Keep an Eye on the Lock-Up Period
Once the lock-up period expires, typically 3-6 months after the IPO, all insiders, including management, employees, and venture capitalists are free to sell their shares. You can generally expect the share price to dip once the lock-up ends as these early investors exit, which shouldn’t be a cause for too much concern.
However, the scale of the dip is where your attention should be focused. If insiders are reducing their exposure by a significant amount, especially the management team, then it can be a sign that their confidence in the business’s future is poor. A major sell-off by insiders should set alarm bells ringing for investors.
The opposite is also true, if the end of the lock-up period passes with just a poor proportion of shares being sold then you can infer that insiders have confidence in the business and its future.
2. Read Quarterly Reports
As with any investment, keep track of the quarterly financial reports, these give you the chance to interrogate your investment’s performance. The first quarterly report released following the IPO is particularly important as it will provide you with the first in-depth update following the publishing of the prospectus before the IPO.
You should be particularly interested in signs of growth, as the primary reason for releasing an IPO is gathering capital for expansion. Watch how revenue levels have changed over time as well as the net gains/losses.
Particularly in the early reports, it is important to see signs of pending expansion, such as increased marketing, product development, and operations costs. Growth following the IPO will drive the share price bringing you investment returns.
3. Watch the Market
Watch the performance of the market as a whole, focusing on the specific industry and competitors of your investment. A broad understanding of the market is key to contextualising performance.
For example, AirBnB’s first quarterly report noted that revenue was down 22% year-over-year yet this decrease was mostly caused by the COVID-19 pandemic and not poor business choices.
While this example may seem obvious, it shows how important market context is for investors. Without understanding the market you will be wholly unable to evaluate performance.
4. Changes in the Management Team
The period immediately following the IPO is crucial for the long-term success of the business, as it seeks to make the most of the capital raised by the sale. An experienced and well-qualified management team is essential to navigating this period successfully, leading to better returns for you as an investor.
Should key members of the team pre-IPO begin to change then it should be a cause for concern. If individual members are being forced out it may suggest that the company isn’t performing as well as expected, with these members being held accountable by the board.
Conversely, if experienced members of the team are leaving it may suggest that they are unhappy with the direction of the business, again a serious cause for concern.
5. Flip or Hold?
When it comes to IPOs there are two broad schools of thought, you can either flip your shares for a quick profit or hold them to benefit from long term growth.
Flipping is by far the riskier of the two strategies, and as a result, typically requires more experience in trading in general. To flip shares in an IPO ideally you need to pick a company that has either been undervalued or is subject to extreme levels of demand and popularity. However, this can be difficult to discern, especially for less experienced investors.
However, flippers can benefit greatly from early bull markets, especially in the first days and weeks of trading, when many companies see unprecedented peaks in share price which may not be repeated for months or even years.
Bumble’s IPO this year is a great example, with the share price peaking 6 days after the IPO, a peak that has yet to be exceeded.
For less experienced investors who are willing to wait to see a return on their investment holding is recommended. Provided that the company has strong fundamentals and a robust business model and an outlook of growth it can be wise to hold your investment, potentially for several years, to make the most of post-IPO share prices.
Holding is particularly strong when it comes to large tech IPOs which tend to appreciate in value significantly in the long-term. While the share price may fluctuate a large amount in the first year of trading, this tends to level out and make way for steady growth for strong IPOs, with Alphabet, Facebook, and Visa all seeing consistent long-term growth over the last decade.
"Yes, IPOs are a good investment but you can't measure them as typical investments. Obviously, this comes from the lack of financial metrics that you have access to before the IPO. However, if it's a company that you believe in regardless of financial statements then it can be an opportunity to get in at the lowest price point and hold for the next 10 years. That is what I did with Airbnb. With that said, Airbnb is a company I plan to hold for +10 years. The reason it's not a good idea is the risk of not knowing numbers, but I view this as a positive because if I am buying a company because of the brand then I won't feel the need to sell when the numbers take a dip or don't reflect what I believe the true value of the company to be." - Vicente Lizcano, Nimaroh Creative House
While both strategies can be useful in different scenarios it is incredibly important to come up with an exit plan before you invest, as this will inform the types of IPO you choose to invest in.