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An initial public offering (IPO) is Wall Street’s version of a celebration — it marks when a company makes the leap from being privately held to becoming a publicly traded stock. Like any good party, many people want an invitation to buy shares of a company the first time it’s offered on a stock exchange.
Problem is: The most coveted tickets — buying shares at the IPO price that’s announced in advance of its debut — are generally reserved for investment banks, institutional investors, hedge funds, and some high-net worth investors. For the rest of us, we’ll have to wait until the stock begins trading on a stock exchange to get in on the action.
Still, it’s often difficult to ignore the buzz around these deals, particularly when there’s a hot market for IPOs. Midway through 2021, the number of IPOs on U.S. exchanges had already surpassed the full-year totals for each of the years from 2015 through 2019, according to figures from Renaissance Capital.
Recent years have seen some high-profile IPOs, including Uber, Lyft, Airbnb, Roblox, Coinbase, and soon Robinhood. And there’s an eager audience for newly public companies, thanks to near-zero interest rates that encourage investing in more speculative assets and the rise of more active individual investors. Earlier this year, a floodgate opened on a different way for companies to go public via a SPAC, or Special Purpose Acquisition Company.
Buying a stake in a company as soon as it goes public has mixed results, however. Over a 40-year span, IPOs posted average first-day gains of about 18%, according to data compiled by Jay Ritter, a professor at the University of Florida. But those early gains may not last. A majority (56%) of nearly 8,000 IPOs that priced between 1975 and 2015 had a negative 5-year return — meaning the stock was worth less than its initial offering, according to Ritter’s data.
And therein lies the rub of investing in IPO stocks: While they’re tantalizing to many investors who want to find the market’s next winners, there are some losers strewn in the mix.
How an initial public offering works
When a private company announces that it intends to go public, leadership may opt for doing so through an IPO. By offering shares to a broader swath of investors (i.e. the general public), the company is seeking to raise money to expand its operations.
Even before an IPO announcement is made, there’s been a lot of behind-the-scenes work over the preceding months (or even years) to shore up the company’s financials and make it IPO-ready. Public companies are required to disclose a wide array of information about financial performance, operations, and management. The company typically finds an underwriter for the deal, often an investment bank, then goes on a “roadshow” to gin up interest in the stock among institutional investors.
The company must also file an S-1 prospectus with the U.S. Securities and Exchange Commission (SEC) in connection with its initial public offering. This document details information about the company’s financials, how the proceeds from the offering will be used, how its valuation was determined, the number of shares to be offered, among other information.
Finally, once the IPO shares are offered to any investor in the stock market, the company is officially a publicly-traded entity.
Who can invest in an IPO
By the time a company’s leaders ring a bell at the New York Stock Exchange or Nasdaq Exchange to celebrate going public, however, a majority of its shares have already been allocated to various types of professional investors — including hedge funds, institutions or company insiders like executives and employees.
You may be able to request allocation of shares at the IPO price through your online brokerage, though the number of shares you receive may be less than you request (or even none at all). Schwab requires customers to fill out an eligibility questionnaire, while Fidelity has minimum asset requirements ($100,000 or $500,000, depending on the IPO), and most of Robinhood’s customers have access to IPOs.
If you can’t participate in the IPO before it’s public, you may buy IPO stocks as soon as they begin trading on the stock market — though most likely at a premium.
Risks of IPOs
There often is considerable hype surrounding IPOs of well-known companies, and that doesn’t always mean the stock ends up being a good investment. Even some of the biggest IPOs of the past decade, like Facebook or Alibaba, went through months-long periods in which the stock was trading below its offer price.
Beyond the risks of investing in any individual stock, there are additional risks associated with IPOs. Newly public companies may still be finding a path to profitability, have a management team that’s relatively untested (particularly as a public company), and may disappoint on the stock market’s expectations. As with any investment decision, it’s important to do your research in advance by reading the S-1 prospectus and other information.
How IPO stocks fit in your portfolio
The allure of buying shares of a company early on, before its stock potentially skyrockets, causes many investors to overlook those aforementioned risks. Doing so could increase the risk in your overall portfolio, however.
Buying shares of a newly public company isn’t the only way to participate in the IPO. Many of these stocks will be added to a major stock market index, like the Russell 2000 or even the S&P 500. As a result, if you invest in index funds that track these benchmarks, you may benefit (to a lesser degree, of course) from potential gains in an IPO.
Finally, there are also some mutual funds that invest in pre-IPO shares, and there are currently nine exchange-traded funds (ETFs) that track the IPO market, according to information from ETF.com.
How to buy IPO stocks
To participate in an IPO at its initial offering, you’ll need to go through a few basic steps:
- Do your research. Don’t get swept up in the hype of a hot IPO and ignore doing the necessary research to determine if the stock is a good investment. Diving into the financial information in advance may help you to steer clear of those IPOs that are more fizzle than sizzle.
- Check your eligibility. Some IPOs may be more readily available to retail investors than others are, and you may need to prove eligibility (like with those minimum asset requirements mentioned above) to actually buy shares.
- Request shares. Assuming you’ve passed that eligibility hurdle, you may need to fill out a form with your broker (an indication of interest, or IOI) to actually request shares. Think of this number as a maximum — you’ll likely receive fewer shares.
- Confirm your order. Prior to the IPO’s pricing, you’ll need to actually place an order — just as you would for any other stock purchase.
If you don’t qualify to buy an IPO before it’s available to the general public through your brokerage account, you’ll have to wait until the stock debuts on an exchange. At that point, buying an IPO is just like any other stock: You’ll need to decide how many shares to buy.
Even if you don’t get in early, like the first time shares are trading, you may not necessarily miss out by buying later. The price fluctuations that many IPOs experience means that you may actually be able to buy at a cheaper price down the road. And there’s an additional twist with IPOs: A lock-up period, typically lasting 90 to 180 days, during which time company insiders can’t sell their shares. When that lock-up period expires, there may be some selling among those parties.
Finally, that stat about the average five-year performance bears repeating: While there are some tremendous success stories, results will vary, so it’s important to have a long-term mindset when investing in IPOs.