By Kate Ashford, John Schmidt
An IPO is an initial public offering. In an IPO, a privately owned company lists its shares on a stock exchange, making them available for purchase by the general public.
Many people think of IPOs as big money-making opportunities—high-profile companies grab headlines with huge share price gains when they go public. But while they’re undeniably trendy, you need to understand that IPOs are very risky investments, delivering inconsistent returns over the longer term.
How Does an IPO Work?
Going public is a challenging, time-consuming process that’s difficult for most companies to navigate alone. A private company planning an IPO needs not only to prepare itself for an exponential increase in public scrutiny, but it also has to file a ton of paperwork and financial disclosures to meet the requirements of the Securities and Exchange Commission (SEC), which oversees public companies.
That’s why a private company that plans to go public hires an underwriter, usually an investment bank, to consult on the IPO and help it set an initial price for the offering. Underwriters help management prepare for an IPO, creating key documents for investors and scheduling meetings with potential investors, called roadshows.
“The underwriter puts together a syndicate of investment banking firms to ensure widespread distribution of the new IPO shares,” says Robert R. Johnson, Ph.D., chartered financial analyst (CFA) and professor of finance at the Heider College of Business at Creighton University. “Each investment banking firm in the syndicate will be responsible for distributing a portion of the shares.”
Why Do an IPO?
An IPO may be the first time the general public can buy shares in a company, but it’s important to understand that one of the purposes of an initial public offering is to let early investors in the company cash out their investments.
Think of an IPO as the end of one stage in a company’s life-cycle and the beginning of another—many of the original investors want to sell their stakes in a new venture or a start-up. Alternatively, investors in more established private companies that are going public also may want the opportunity to sell some or all of their shares
“The reality is that there’s a friends and family round, and there are some angel investors who came in first,” says Matt Chancey, a certified financial planner (CFP) in Tampa, Fla. “There’s a lot of private money—like Shark Tank-type money—that goes into a company before ultimately those companies go public.”
There are other reasons for a company to pursue an IPO, such as raising capital or boosting a company’s public profile:
- Companies can raise additional capital by selling shares to the public. The proceeds may be used to expand the business, fund research and development or pay off debt.
- Other avenues for raising capital, via venture capitalists, private investors or bank loans, may be too expensive.
- Going public in an IPO can provide companies with a huge amount of publicity.
- Companies may want the standing and gravitas that often come with being a public company, which may also help them secure better terms from lenders.
While going public might make it easier or cheaper for a company to raise capital, it complicates plenty of other matters. There are disclosure requirements, such as filing quarterly and annual financial reports. They must answer to shareholders, and there are reporting requirements for things like stock trading by senior executives or other moves, like selling assets or considering acquisitions.
Key IPO Terms
Like everything in the world of investing, initial public offerings have their own special jargon. You’ll want to understand these key IPO terms:
- Common stock. Units of ownership in a public company that typically entitle holders to vote on company matters and receive company dividends. When going public, a company offers shares of common stock for sale.
- Issue price. The price at which shares of common stock will be sold to investors before an IPO company begins trading on public exchanges. Commonly referred to as the offering price.
- Lot size. The smallest number of shares you can bid for in an IPO. If you want to bid for more shares, you must bid in multiples of the lot size.
- Preliminary prospectus. A document created by the IPO company that discloses information about its business, strategy, historical financial statements, recent financial results and management. It has red lettering down the left side of the front cover and is sometimes called the “red herring.”
- Price band. The price range in which investors can bid for IPO shares, set by the company and the underwriter. It’s generally different for each category of investor. For example, qualified institutional buyers might have a different price band than retail investors like you.
- Underwriter. The investment bank that manages the offering for the issuing company. The underwriter generally determines the issue price, publicizes the IPO and assigns shares to investors.
SPACs and IPOs
Recent years have seen the rise of the special purpose acquisition company (SPAC), otherwise known as a “blank check company.” A SPAC raises money in an initial public offering with the sole aim of acquiring other companies.
Many well-known Wall Street investors leverage their established reputations to form SPACs, raise money and buy companies. But people who invest in a SPAC aren’t always informed which firms the blank check company intends to buy. Some disclose their intention to go after particular kinds of companies, while others leave their investors entirely in the dark.
“It’s giving your money to an entity that doesn’t own anything but tells you, ‘Trust me, I’ll only make good acquisitions with it,’” says George Gagliardi, a CFP in Lexington, Mass. “Like a baseball batter wearing a blindfold, you don’t know what’s coming at you.”
Many private companies choose to be acquired by SPACs to expedite the process of going public. As newly formed companies, SPACs don’t have long financial histories to disclose to the SEC. And many SPAC investors can recoup their money in full if a SPAC does not acquire a company within 24 months.
SPAC IPOs comprised more than half of the IPOs in the U.S. in 2020, according to Goldman Sachs. In the first three weeks of 2021, 56 U.S. SPACs went public.
IPO activity hit record highs in 2021, thanks to the very strong stock market. The IPO outlook for 2022 is very different, with expected initial offerings being postponed and even cancelled thanks to the many issues facing the market. Here are some of the more prominent upcoming IPOs:
|Company||Industry||Most Recent Valuation|
|Stripe||Financial services||$95 billion|
|Chime||Financial services||$40 billion|
|Databricks||Database management||$38 billion|
|Discord||Social networking||$17 billion|
|Soical media||$15 billion|
|Plaid||Financial services||$13 billion|
|Impossible Foods||Consumer staples||$10 billion|
How to Buy IPOs
Buying stock in an IPO isn’t as simple as just putting in your order for a certain number of shares. You’ll have to work with a brokerage that handles IPO orders—not all of them do.
“Typically you’d have to buy IPO stock through your stock broker, and on rare occasions, directly from the underwriter—i.e., knowing someone at the company or investment bank,” says Gregory Sichenzia, founding partner of Sichenzia Ross Ference, a New York City-based securities law firm.
Brokers like TD Ameritrade, Fidelity, Charles Schwab and E*TRADE may offer access to IPOs. At many firms, though, you’ll also need to meet certain eligibility requirements, such as a minimum account value or a certain number of trades transacted within a certain time frame.
Perhaps most importantly, even if your broker offers access and you’re eligible, you still might not be able to purchase the shares at the initial offering price. Everyday retail investors generally aren’t able to scoop up shares the instant an IPO stock starts trading, and by the time you can buy the price may be astronomically higher than the listed price. That means you may end up purchasing a stock for $50 a share that opened at $25, missing out on substantial early market gains.
To help combat this, platforms like Robinhood and SoFi now enable retail investors to access certain IPO company shares at the initial offering price. You’ll still want to do you research before investing in a company at its IPO.
Should You Invest in IPOs?
As with any type of investing, putting your money into an IPO carries risks—and there are arguably more risks with IPOs than buying the shares of established public companies. That’s because there’s less data available for private companies, so investors are making decisions with more unknown variables.
Despite all the stories you’ve read about people making bundles of money on IPOs, there are many more that go the other way. In fact, more than 60% of IPOs between 1975 and 2011 saw negative absolute returns after five years.
Take Lyft, the ride-share competitor to Uber. Lyft went public in March 2019 at $78.29 per share. The stock price dropped immediately, and within a year, it reached a low around $21. The stock price has recovered somewhat, and as of writing the price was above $57. But even if you had bought in when Lyft went public, you still wouldn’t have recouped your investment.
Other companies do well over time, but stumble out of the gate. Peloton was supposed to go public at $29 per share but opened in September 2019 at $25.24 and struggled for the first six months, hitting $19.72 in March 2020. It’s considered the third worst mega-IPO debut in history. (A mega-IPO, or Unicorn IPO, is an IPO of a company valued at more than $1 billion.) If you stuck with Peloton, you’d have seen its stock rise to $154.67 by February 12, 2021. The question is—would you have been able to hold on through Peloton’s lows to reach its Covid-19-induced highs?
“Just because a company goes public, it doesn’t necessarily mean it’s a good long-term investment,” says Chancey. Take Y2K’s most infamous victim, Pets.com, which went public, netting about $11 per share, only to have its price crater to $0.19 in less than 10 months due to massive overvaluation, high operating costs and the Dot Com market crash.
Conversely, a company might be a good investment but not at an inflated IPO price. “At the end of the day, you could buy the very best business in the world, but if you overpay for it by 10 times, it’s going to be really hard to get your capital back out of it,” Chancey says.
“Buying IPOs, for the majority of buyers, isn’t investing—it’s speculating, as many of the shares allocated in the IPO are flipped the first day,” says Gagliardi. “If you really like the stock and plan to hold it as a long-term investment, wait a few weeks or months when the frenzy has disappeared and the price has come down, and then buy it.”
A Diversified Approach to IPO Investing
If you’re interested in the exciting potential IPOs but would prefer a more diversified, lower risk approach, consider funds that offer exposure to IPOs and diversify their holdings by investing in hundreds of IPO companies. The Renaissance IPO ETF (IPO) and the First Trust US Equity Opportunities ETF (FPX), for example, have returned 18.35% and 13.92% since inception, respectively. The S&P 500, a major benchmark for the U.S. stock market, on the other hand, has seen average returns of about 10% for the past 100 years.
Yes, you may see slightly higher highs with IPO ETFs than with index funds, but you also may be in for a wild ride, even from one year to the next. According to Fidelity, between 2009 and 2018, one-year U.S. IPO returns hit a low of -9% in 2015 only to skyrocket to 44% in 2016. That’s why most financial advisors recommend you invest the bulk of your savings in low-cost index funds and allocate only a small portion, generally up to 10%, to more speculative investments, like chasing IPOs.