When you first get started investing, you’re bound to spend ample time learning about everything from how the stock market works to what a portfolio is. Over the course of your research, you’ll likely read about initial public offerings, or IPOs, and see financial experts refer to them pretty frequently, too.
If you plan to start investing in the stock market, it’s vital to understand what IPOs are and how they work; they’re your first opportunity to buy shares in certain companies — and you can often use that to your advantage. To help you along on your trading journey, we’re taking a look at what IPOs are, what a company’s IPO development process looks like and how you can determine which IPOs are worth investing in based on your personal financial strategy.
What Are Initial Public Offerings?
The IPO process encompasses the steps a private company goes through to begin offering shares on the stock market. Until a company goes public, it’s usually backed by a small handful of investors. These can range from the very earliest shareholders, such as the founders and their family or friends, to professional investors like venture capitalists or angel investors. Before a company goes public, it’s typically privately owned. It might have stocks and shareholders, but those stocks, each of which represents a small portion of ownership in the company, aren’t traded on public stock exchanges.
When the company goes public with an IPO, it not only allows the public to invest in the company, but also allows its earlier investors the chance to cash out if they choose. “Going public” means that those shares that were only available to certain shareholders are now available to all investors. Private companies go public for a variety of reasons, including the possibility of raising capital by selling their shares on the stock market. The company can then use the capital to expand the business, fund research or grow in whatever way its leaders choose.
The Long Road to an IPO
So, how does a company start offering shares on stock exchanges? The IPO process can be challenging and generally takes anywhere from six months to over a year to complete. Before the company can list on the market, it must first go through a lengthy pre-marketing phase.
Initially, the company will select an underwriter, which usually takes the form of an investment bank, to handle key tasks. Some companies hire multiple underwriters to help with different parts of the process. It’s the underwriter’s job to figure out how to divide company ownership into shares and how to price those shares, all while meeting the extensive financial regulations newly public companies must adhere to. Underwriters may also broker initial sales of the IPO stocks to larger investors like mutual fund companies.
At this point, the IPO company may also bring in lawyers, accountants and consultants who specialize in helping to meet the rigorous demands of the Securities and Exchange Commission (SEC) — the federal agency that’s responsible for managing and regulating financial products in the U.S. The company must meet not only the SEC’s filing requirements to become publicly traded but must also meet the listing requirements of the stock exchange it plans to list on.
Once everything is in place, the company files an S-1 Registration Statement, which consists of both a prospectus and filing information — think of it like a job application for the company’s stocks to get listed. It’s common for the S-1 to be revised a great deal throughout the pre-IPO process, as things like the expected filing date are subject to change.
Underwriters and marketing experts play key roles in determining the initial asking price of the company’s shares. They often go on what are referred to as “roadshows,” in which they schedule meetings with potential investors to gauge interest. After everything is decided, the company finally makes its shares available for purchase on its selected IPO date.
Understanding Initial Public Offerings vs. Direct Public Offerings
It’s important to note that IPOs aren’t the same thing as direct public offerings. In a direct public offering, everyone has access to shares and the ability to buy them as soon as they list on a public exchange. In this type of offering, no shares will have yet been publicly sold.
IPOs are a bit different in that some shares are actually offered for purchase before they’re fully accessible to all investors on the market. Because there may only be a limited number of shares made available at first, not everyone will be able to purchase or even have access to them until they become public.
Additionally, not all brokers offer access to the ability to purchase IPOs before they’re made public, though it’s beginning to become more common. Some online brokers, such as TD Ameritrade, Fidelity, Charles Schwab, Robinhood and SoFi, already offer their customers access to certain IPOs, though you may have to meet certain eligibility requirements. Do your research to understand whether you qualify to purchase these listings and what they involve.
The Pros and Cons of IPO Investing
Just like any investment, you should always do your due diligence before investing in a stock that’s brand new to the market. Investing in IPOs can feel like a trading style all its own, so it’s important to be aware of both the potential advantages and risks.
Pros
- It’s common for IPOs to be underpriced in the hope that this will help generate sales. If you’re able to get in on the ground floor, you may be able to score a deal if the share prices go on to rise substantially over the long run.
- When the shares finally appear on the public market, their prices generally experience a great deal of volatility for the first few days. Even if you’re not interested in holding the shares for the long term, you can make a great deal of money if you time your selling right during the initial price hike.
Cons
- The initial price volatility of IPOs can be as big of a risk as a potential gain. Just as easily as the price of your shares can shoot up, it can also plummet in a matter of minutes.
- IPO share purchases are usually conditional and not always guaranteed. Additionally, it can be hard to gauge the price at which the shares will actually list. This information is usually decided right before shares are made available for purchase.
- Depending on which broker you use, you may not have the right level of access to purchase IPOs before they appear on the market — or you only might if you meet certain account requirements.
How to Invest in IPOs Wisely
If you do decide to invest in an IPO, it’s essential to pick your investments carefully. Some of the things you’ll want to take into account include the following:
- Learn as much as you can about the company, including how well it’s performed in comparison to its competitors and how financially healthy its sector is overall.
- Go over the company’s prospectus, but keep in mind that it’s designed to look as flattering as possible. Concentrate instead on the cold hard facts it discloses. Is the company going public in an attempt to raise capital for research or expansion? Or does it appear to be going public because it’s racked up debts it may not be able to pay?
- Look at the company’s underwriter. Generally, high-quality companies attract stronger underwriters with solid track records and reputations.
In short, do as much research about the company as possible — and don’t be afraid to be picky. It can be exciting to invest in an IPO, but it’s vital to ensure doing so makes sense for your portfolio and goals.
