The term initial public offering (IPO) slipped into everyday speech during the market boom experienced in the recent past. Back then, it seemed you couldn’t go a day without hearing about the latest IPO. Investors were ever willing to invest in these IPOs. Most of these IPOs were profitable. Yet, there were also IPOs that experienced huge first-day gains but ended up disappointing investors in the long term. However, investors who had the foresight to exit the stock at the optimal level were rewarded with impressive capital gains.
Even though the interest for IPOs declined, it continues to be a profitable investment. The focus has shifted from quick money to a long-term outlook. Rather than trying to capitalize on a stock’s initial bounce, investors are more inclined to carefully scrutinize long-term prospects.
Even if you have a longer-term focus, finding a good IPO is difficult. IPOs have many unique risks that make them different from the average stock, which has been trading for a while. If you do decide to take a chance on an IPO, the article will help you understand the characteristics and risks associated with investing in IPOs.
What is an IPO?
Historically, an IPO has referred to the first time a company offers its shares of capital stock to the public. IPOs are often issued by smaller, younger companies seeking capital to expand but they can also be done by large privately-owned companies. In an IPO, the issuer obtains the assistance of an underwriting firm, which helps determine what type of security to issue, the best offering price, the amount of shares to be issued and the time to bring it to market.
For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data to use to analyse the company. Also, most IPOs are for companies that are going through a transitory growth period, which means that they are subject to additional uncertainty regarding their future values. Thus, investing in IPOs should be undertaken with caution.
Don’t just jump in
Obtaining information about IPO
When issuing shares to the public, the company issues a document named prospectus. It is a formal legal document that provides details about the company. You should read the prospectus carefully and ask your advisor any questions you may have. The prospectus is divided into various sections, including the following:
Prospectus summary – Briefly summarizes information disclosed in more detail in the prospectus.
Risk factors – This section describes relevant risks associated with an investment in the company and the securities being offered.
Use of proceeds – Specifies how the company plans to use the proceeds it receives from the IPO.
Dividend policy – This describes the company’s history of paying dividends and what its intentions are in that regard.
Dilution – This section compares the price that investors are paying for the stock in the IPO to the book value of the stock and the average price paid by the existing shareholders. Often, there is a meaningful disparity in this comparison.
Capitalization – A table describes the company’s outstanding indebtedness and securities on a pro forma basis (assuming completion of the IPO).
Selected financial data – This section shows certain key financial and other data in a summary tabular format. Its purpose is to enable investors to focus on key information and to identify trends. Normally this data is provided for the prior five fiscal years, plus any interim quarterly periods.
Management’s discussion and analysis – In this section, the company’s management provides its narrative perspective on the company’s financial results, condition, liquidity and capital resources and contains an explanation for changes in the company’s financial results from year to year.
Business – This section describes the company’s products, services, markets, strategies, competition, properties and litigation.
Management – This section includes biographical information about the company’s directors and executive officers, as well as an employment or related contracts and other relationships with them.
Principal shareholders – This provide information on the ownership of the company’s stock by its officers, directors and principal shareholders.
Financial statements – This section provides financial statements on the company’s financial condition and performance and notes to the financial statements. Typically, the financial statements cover historical data.
Risks and other factors to consider
IPOs can be speculative investments and involve special risks and other considerations which are important to take into account when making a purchase decision. Some of those risks and considerations are described below. The prospectus for each IPO will contain a ‘risk factors’ section that describes the specific risks applicable to that IPO, including risks associated with the company and the common stock.
Offering price. The public offering or IPO price is determined by the company in consultation and negotiation with the underwriters, taking into account market condition, analyses of possible valuations and the underwriters’ order book. The order book is a compilation of investors’ indications of interest, showing how many shares each investor would be willing to buy and at what price. The public offering price is not a reflection of the market price, as no market price has been established prior to the IPO. It is important to understand that competing interests affect the determination of the public offering price. On the one hand, the company seeks to maximize the public offering price because the higher the price the more capital it can raise without having to issue more shares. Underwriters are interested in a high price in order to meet the company’s objectives but at the same time they want a price that is attractive to investors. Underwriters thus have an incentive to price an IPO that will increase demand and enable the underwriters to sell all of the shares. Often, the market or trading price of shares that were offered in an IPO may vary dramatically from the IPO price, even shortly after the IPO is completed. The market price can be higher or lower than the IPO price.
Market risk. The market price of shares issued in the IPO will move up or down based on various factors, including macroeconomic conditions, governmental policies, prevailing interest rates, movements in the stock markets generally, consumer and investor sentiment, conditions or developments affecting the industry or sector in which the company operates and conditions, events or developments that are specific to the company.
Price volatility and liquidity risk. The market price of shares issued in an IPO may fluctuate significantly, particularly in the brief period of time after the IPO. The market price may also be affected by a limited supply of shares in the market following the IPO. The shares that are traded in the early days after the IPO are generally only those that were sold in the IPO. Other outstanding shares, such as those held by founders, early investors and employees that have not been included in the IPO, may not be sold in the public market because they have resale restrictions or limitations or may be subject to lock-up agreements. Although shares issued in an IPO may be listed on a national exchange and be freely saleable, trading volumes may be limited because of supply and demand which may create challenges in selling the shares in sufficient quantities or at attractive prices.
Market overhang. When a company does an IPO, it is only registering and selling a certain number of shares. The company will have other shares outstanding which are not included in the IPO. Many of the outstanding shares may be restricted from trading at the time of the IPO, with those restrictions lapsing or expiring at certain points in time. As any restrictions lapse or expire on outstanding shares, the market price may decline because of a potential increase in the supply of shares that can be sold. The company will describe the number of its outstanding shares and the applicable restrictions on the resale of those shares in the prospectus for the IPO.
Market capitalization. Some IPO companies may have smaller market capitalizations. A company’s market capitalization is determined by multiplying the market price of its commons stock by the number of outstanding shares. Companies with smaller market capitalizations involve greater risk than larger companies. Stocks of smaller companies tend to be more volatile and less liquid than larger companies. The frequency and volume of trading of smaller company stocks may be substantially less than is typical of larger companies. Smaller company stocks are more likely to be adversely affected by poor economic or market conditions. Smaller companies may also lack management depth and experience, financial resources and product or customer diversification, making them more susceptible to market pressure and business failure.
Specific company risk. Any investment in an IPO involves risks specific to the company and its business, products, strategies and prospects. Such risks are described in more detail in the prospectus for that company.
Before investing in an IPO, it is important to understand and discuss with your investment advisor the terms of the offering and company’s business and the potential risks. Investors in IPOs should have a high tolerance for risk, including the willingness and ability to accept significant price volatility, potential lack of liquidity and potential loss of their investment. Before buying shares in an IPO, you should obtain and read the prospectus carefully.
By no means are we suggesting that all IPOs should be avoided: some investors who have bought stock at the IPO price have been rewarded handsomely by the companies in question. Every month successful companies go public but it is difficult to sift through the riffraff and find the investments with the most potential. Just keep in mind that when it comes to dealing with the IPO market, a sceptical and informed investor is likely to perform much better than one who is not.