Understanding IPOs: A Guide to Investing in Initial Public Offerings

Key Points

• An IPO, or initial public offering, marks the transition of a private company to public ownership.
• Investing in IPOs involves understanding the unique risks and rules associated with trading these securities.
• Researching the issuing company and its preliminary prospectus is crucial before investing.

An investment in an IPO has the potential to deliver attractive returns. However, prior to investing, it is important to understand how the process of trading these securities differs from ordinary stock trading, along with the additional risks and rules associated with IPO investments.

What is an IPO?

When a private company first sells shares of stock to the public, this process is known as an initial public offering (IPO). In essence, an IPO means that a company's ownership is transitioning from private ownership to public ownership. For that reason, the IPO process is sometimes referred to as "going public."

Startup companies or companies that have been in business for decades can decide to go public through an IPO. Companies typically issue an IPO to raise capital to pay off debts, fund growth initiatives, raise their public profile, or to allow company insiders to diversify their holdings or create liquidity by selling all or a portion of their private shares as part of the IPO.

In an IPO, after a company decides to "go public," it chooses a lead underwriter to help with the securities registration process and distribution of the shares to the public. The lead underwriter then assembles a group of investment banks and broker dealers (a group known as a syndicate) that is responsible for selling shares of the IPO to institutional and individual investors.

In addition to IPOs, there are other types of equity new issue offerings for companies with stocks that are already publicly traded, including:

• Follow-on offering: An issuance of additional shares of stock by a company that is already publicly traded.
• Secondary offering: A registered sale of previously issued securities held by large investors.

Do your homework before you invest

If you are considering investing in an IPO, it is also important to avoid getting swept up in the hype that can surround a promising young company. Many companies have debuted with high expectations, only to struggle and go out of business within a few years.

Investors became acutely aware of these risks while investing in IPOs during the technology stock boom and bust of the late 1990s and early 2000s. This was a highly speculative period in US stock market history and, as a result, some investors earned impressive gains on their IPO investments, while others experienced significant losses after shares of various technology stocks plummeted.

Before investing, be sure to do your own due diligence. This task can be challenging because of the lack of readily available public information on a company that is issuing stock for the first time. However, you should always refer to the issuing company’s preliminary prospectus, also known as a "red herring." This document, provided by the issuer and lead underwriter, will include information on the company's management team, target market, competitive landscape, the company's financials, and potential risks.

Participating in an IPO

When you participate in an IPO, you agree to purchase shares of the stock at the offering price before it begins trading on the secondary market. This offering price is determined by the lead underwriter and the issuer based on a number of factors, including the indications of interest received from potential investors in the offering.

Before you can invest in an IPO, you first need to determine if your brokerage firm offers access to new issue equity offerings and, if so, what the eligibility requirements are. Typically, higher-net-worth investors or experienced traders who understand the risks of participating in an IPO are eligible.

Assuming you have done your research and have been allocated shares in an IPO, it is important to understand that while you are free to sell shares obtained through an IPO whenever you deem appropriate, many firms will restrict your eligibility to participate in future offerings if you sell within the first several days of trading.

Historical returns of IPOs

It's also important to remember that there is no guarantee that a stock will continue to trade at or above its initial offering price once it starts trading on a public stock exchange. That said, the reason most people invest in IPOs is for the opportunity to invest in the company relatively early in its life cycle and profit from potential future growth.

A review of historical data dating back to 2012 shows that annual returns on IPOs have varied widely from one year to the next.

Investing in a newly public company can be financially rewarding; however, there are many risks, and profits are not guaranteed. If you're new to IPOs, be sure to review all of our educational materials on this topic before investing.