An IPO – Initial Public Offering – refers to the first time a firm’s shares are sold to the general public. Trading commences at the start of a trading day, with the new stock listed for the first time, and there is normally a flurry of buying – and sometimes selling – activity. The main drivers of price during an IPO are the actions of industry insiders, views of analysts and financial media, and the reported figures of the company to date. IPOs are an expensive business for the company, involving the services of several different investment banks and brokers who act as underwriters for the IPO, and have an immense influence on the eventual success and pricing of the stock. Should an IPO underperform, it is their bankers who will often face the fiercest criticism, as this raises the spectre that they offered an unrealistically high ‘launch’ price in order to close the deal. Proper due diligence on the part of the launching firm can limit this.
For retail investors, IPOs are an exciting investment, one that can cause headaches (and losses), but which remain very popular given the list of successful IPOs and the pleasure of being amongst the early investors of a growing company. Again due diligence is essential, as some IPOs are catastrophes, with laughably high guidance prices, a sad state of affairs that can be the prelude to a prolonged period of underperformance.
Why do companies use IPOs?
Companies launch their shares on the general market to improve their financing and achieve long-term growth. The IPO gives outside investors the chance to buy a portion of the company, hopefully increasing its overall value, and of course the original owner of the equity – the company itself – benefits from the cash sale. This cash sum raised can then be used to acquire competitors, to buy new equipment or install new technology, hire staff and so on. Often it is also used to pay off earlier investors, many of whom may have only wanted to provide early stage or seed money to the business. In the tech sector especially, an IPO is seen as a point of maturation where early investors leave and a more ‘normal’ structure is adopted.
IPOs provide a one time cash benefit for the company: imagine a situation where a single founder owns 80% of the business, and an investor 20%. The investor wants to liquidate his holdings completely, having provided initial funds to launch the business, and the founder wants to sell 29% to allow for the maximum possible fundraising without losing overall control (he retains 51%). For ease of the example, we will imagine that there are one million shares in total, and the underwriting bank (normally there would be two or more) has priced them at $10 each, for a total valuation of $10 million. A sale of 49% of the shares, assuming all are sold at the price offered, would involve the founder selling 290,000 shares and raising $2.9 million, while the investor collects $2 million for his (or her) shares.
Can you buy shares before an IPO?
Banks will look to have many of the shares pre-sold, to ensure sufficient trading volumes on day one, sometimes offering slight discounts from the initial price to do so, or guaranteeing them at the launch price. The problem with this is that if, as sometimes happens, the first day of trading sees shares increase in value by 50%, the founder has essentially undervalued his stake in the company severely, and cut himself out of 50% of the funds he should have raised. Banks will often slightly underprice IPOs so that the first day ends positive, but when this move is significant – say more than 10% – questions will be asked about the quality of their underwriting team.
These presales are sometimes extended to retail investors, especially those with a history of investing in IPOs or larger sums of money to invest. Investors need to think carefully about investing in presales, as IPOs can also see negative price moves on day one, although this is not usually the case. It can be harder to perform due diligence on a pre-launch company, as one of the requirements of listing on any stock exchange is to provide enhanced disclosures about the operations of your business.
Share types
Some recent IPOs, especially in the tech sector, have used novel share classes to separate out different types of investor. One of the most common is to have Class A shares and Class B shares, where Class B shares have reduced or no voting rights. Some investors will not care about this, but it is worth bearing in mind this means external investors will have no say in the overall direction of the company or at board meetings. Businesses which run a loss as part of their overall model often do this to stave off attacks by activist investors.
Points to consider for retail investors
Retail investors can benefit from IPOs, which often allow an entry point into a growing company, but they need to be aware of a few points to do so successfully:
- IPOs often outperform the general market, but they can be disasters.
- It is harder to perform due diligence on unlisted stocks: do not just rely on the brand name of a company.
- Be careful to understand what type of shares are being offered, whether they give voting rights, and what that says about the overall model of the business.
For investors who take on board all of this information, IPOs remain a popular and interesting opportunity. Very short term trading around IPOs is possible, with some traders trying to benefit from the initial market euphoria to enter then exit positions with a profit, but given trading fees and other considerations this is normally a bad idea for retail investors. Better to invest only in the IPOs of businesses where you share a long term view on their future prospects, and view the IPO as an opportunity to make a stable investment.