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Initial Public Offering (IPO) – What It Is and Why Companies Go Public


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Initial public offerings (IPOs) have been the talk of the town on the stock market over the past few years, attracting new investors to potentially lucrative opportunities. 

On the other hand, many experts suggest investing in these newly public companies is a gamble. According to Barrons, most IPOs were duds in 2021, but there were some big winners. 

Upcoming IPOs include:

  • Stripe (Mid-2022): Stripe is expected to be the biggest IPO of 2022 with a valuation around $95 billion. 
  • MobileEye (Mid- to Late 2022): Intel plans on spinning off its autonomous driving company with a valuation around $50 billion. 
  • Discord (Mid-2022): Discord is a popular social platform that’s expected to make a splash with its IPO valued around $15 billion. 
  • Reddit (Some Time in 2022): The popular social network hasn’t issued an exact time to expect its IPO, but experts are expecting a valuation around $15 billion. 
  • Zazzle (Summer 2022): This digital marketplace is expected to be valued between $1 and $2 billion. 

Read on to find out what an IPO is, whether you should invest in these companies and, if so, how to do it.  


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What Is an Initial Public Offering (IPO)?

An initial public offering is a private company’s first public stock issuance. The newly public company’s shares will be listed on a major stock exchange like the New York Stock Exchange (NYSE) or the Nasdaq, or on an over-the-counter (OTC) exchange. 

The IPO represents the first time a private company seeks investment dollars from public markets. 

There are multiple different types of IPOs. The type you choose to invest in plays a significant role in the risk you accept when making the investment. 

The Four Most Common Types of IPOs

The most common types of IPOs include:

  • Unicorn Offerings. Startup companies with a private valuation of $1 billion or more are a rarity, which is why they’re called unicorn companies. Throughout 2021 and so far in 2022, the majority of IPO investors have focused their efforts on unicorns. However, these companies tend to experience significantly high valuations, and many take a dive following their public debut. 
  • Spinoff Offerings. Spinoff IPOs are generally better for potential investors because more info about them is available. Spinoff IPOs are subsidiaries of already publicly listed companies that are being spun off into their own entity. As a result, investors have far more publicly available information on the company to analyze before deciding whether to invest, greatly reducing their risk. 
  • OTC Offerings. OTC IPOs are some of the riskiest initial offerings to get involved in because these companies aren’t listed on major public exchanges like the NYSE or Nasdaq and have less stringent reporting and listing requirements. 
  • Traditional Offerings. Traditional IPOs don’t represent unicorn companies that start with mid-to-large-cap valuations. Most IPOs are small-cap companies that see an opportunity to get involved in public markets. Traditional offerings aren’t as risky as OTC offerings, but aren’t as safe as spinoff transactions either. 

How the IPO Process Works for Private Companies Looking to Go Public

Shareholders in private companies are people like founders, family, friends, venture capitalists, and angel investors. When these early investors decide that going public will maximize their returns and offer an opportunity to raise capital for the business, they put the wheels of the IPO process in motion. 

Here are the steps to the IPO process:

Step #1: Reach Out to Underwriters

The process of going public starts with the company reaching out to underwriters and letting them know they’re interested in an initial public offering. Different underwriters submit proposals to the company that include the following information about how they’d take the company public:

  • IPO Price. Also known as the offering price, the IPO price is the price per share the company can expect to raise when the transaction goes live. 
  • IPO Shares & Valuation. The underwriter will also suggest how much the company might be worth in a public transaction and the number of shares the issuer should issue to maximize the aesthetic value of the IPO price. 
  • Time Frame. Finally, the company will receive an estimated amount of time it will take to reach the closing of the transaction. 

The early investors in the private company choose the underwriter after carefully analyzing all proposals they receive. 

Step #2: Team Formation

The company forms a team of experts who will work toward the successful launch of its IPO. The team includes:

  • Underwriters. The underwriters chosen in Step #1 will be charged with underwriting the terms of the transaction as outlined in their proposal. 
  • Corporate Attorneys. Corporate attorneys are brought onto the team to ensure all legal obligations to early shareholders and the public are met. Attorneys also help to ensure documentation meets legal and regulatory requirements for public offerings. 
  • Certified Public Accountants. Publicly traded companies have a legal obligation to share financial data with investors. Hired accountants ensure the disclosed financial information is accurate and up to date. 
  • Securities & Exchange Commission Experts. The United States Securities & Exchange Commission (SEC) must approve all public offerings. Companies typically hire SEC experts to improve their chances of approval for the transaction.  

Step #3: S-1 Registration Statement Prep & Filing

An SEC document known as the S-1 Registration Statement must be filed in order for an IPO to take place in the U.S. The statement has two parts:

  1. Prospectus. The prospectus generally includes a brief background of the company, the IPO price, the number of shares it’s issuing, the types of securities being issued, whether the transaction is public or private, the names of company leaders, and the names of underwriters and investment banks involved in the process. 
  2. Privately Held Filing Information. This includes any information that would be important for investors to know like business dealings between the company and its directors, planned use of capital proceeds from the transaction, and pricing methodology. 

Step #4: Marketing

The company, its lawyers, and its underwriters form marketing materials, such as articles and brochures, directed to the IPOs target audience of investors. Members of the executive management team also take their message to the road in roadshows, or privately held meetings with family investment offices and accredited investors in an attempt to get them to invest in the company. 

Step #5: Analysis & Adjustments

The underwriters analyze the results of the marketing campaign surrounding the IPO throughout the entire process. Over time, they make adjustments to the transaction that often include:

  • IPO Price. In the stock market, prices are determined by the law of supply and demand. If demand for shares is higher than originally expected, the underwriters may adjust the IPO price upward. If demand doesn’t meet expectations, they may make downward adjustments to the IPO price. 
  • Issuance Date. Underwriters may also change the issuance date on the transaction if there’s not enough initial demand or if market conditions don’t seem quite right for the IPO. 

Pros and Cons of IPOs for Investors

There are benefits and drawbacks to consider when making any investment. IPOs are no different. Some of the most significant pros and cons of IPOs include:

Pros of IPOs for Investors

Some investors love IPOs for the following reasons:

  1. Potential Profits. Some winning IPO investments are massive winners. For example, by the end of 2021, investors who jumped on the Doximity (NYSE: DOCS) IPO had more than doubled their money. 
  2. Excitement. Initial offerings generally experience fast-paced movement in one direction or another, largely driven by a debate surrounding the company’s potential success, or lack thereof. It’s easy to get wrapped up in the debate and become excited about the outcome, making these investments a fun way to tap into the market as long as you can keep your emotions under control
  3. Opportunity to Get In Early. Chances are you’ve heard someone say something to the effect of, “I wish I would have invested in XYZ 10 years ago.” Investors often experience massive long-term gains when they get in early on companies that become market leaders in the future. 

Cons of IPOs for Investors

There are some significant drawbacks to consider before diving into an IPO. Some of the biggest include:

  1. Heavy Due Diligence Required. Research is important when making any investment, but even more so when investing in an IPO. These companies don’t have years of filings and expert articles to fall back on. All their data is relatively new and historic performance data is limited to what the company decides to share about its beginning days, months, and years. It’s important to dive as deep as you can before making an investment in an initial offering. 
  2. Institutional Investors Take the Lead. Institutional investors make big moves in the premarket hours on the date of an IPO. As a result, institutions set the pace for the trading day ahead, taking much of the first session’s opportunity away from individual investors.  
  3. Volatility. Stock prices are known for heavy volatility on their first day in public markets. Although this is a great environment for traders, long-term, risk-averse investors should wait for the hype to die down and a trend to emerge to avoid potential losses. 
  4. Private Shareholders Look for Public Market Profits. Private shareholders who aid in the decision to go public are often looking for an opportunity to cash in on their investments. IPO investors should pay close attention to lockup periods — periods in which company insiders are not able to sell their shares — because insiders may decide to dump shares to take profits once they’re allowed to. A bunch of insiders selling at the end of a lockup period can lead to a flood of supply and downward price pressure. 

Should You Invest in an IPO?

Whether you should invest in an IPO depends on the type of investor you are. These are some traits of the best candidates for investing in an initial offering:

  • You Are Risk Tolerant. IPOs come with significant risks and should only be considered by risk-tolerant investors. Never invest money you can’t afford to lose into an IPO.
  • You’re Young. High-risk investments like IPOs should only be considered by relatively young investors who have time to recover if things go wrong. Those nearing retirement should generally avoid IPOs. 
  • You’re Research-Driven. Successful IPO investors spend significant amounts of time researching opportunities. Your willingness to do the research and ability to analyze the data you find will play a major role in your profitability. 

How to Buy an IPO – 4 Simple Steps for New Investors

If you want to try your hand at IPO investing, you can follow these steps to get your hands on IPO shares:

Step #1: Find Out Which Brokers Will Make Shares Available 

There are a limited number of shares available in an IPO transaction, and those shares are allotted to specific brokerages. Find out which brokers will have IPO shares available before the actual offering. 

You can find this with an online search or reach out to the customer service department of the broker or brokers you already work with. 

Make sure you’ve signed up for the brokerage account you want to use and have the money to buy shares available in your account in advance of the IPO date.

Step #2: Choose Your IPO Strategy

Your strategy for investing in IPOs will play a major role in the amount of risk and potential reward you’re exposed to when you make your moves in the market. Carefully consider the different options and make sure the strategy you choose aligns with your risk tolerance and goals. 

Flipping

IPO flippers buy shares at the launch of the offering with the goal of selling them within days for quick profits. Flipping is a high-risk strategy that requires the use of technical analysis and a detailed risk management plan. 

IPO Day Trading

IPO day traders bank on the volatility experienced in the first few trading sessions of a newly public company. These traders make quick moves in and out of their positions and never hold shares of the company overnight. 

Long-Term Investing

Long-term investors do detailed research prior to the transaction in an attempt to determine the long-term growth prospects of the company. If the offering price seems fair and the investor expects gains, they’ll buy shares and hold them regardless of early volatility. 

Long-term investors are most susceptible to declines when lockup periods end and insiders are able to start selling shares, typically 90 to 180 days following the company’s IPO. If you follow this strategy, it’s important to look into how many insider shares exist, know when lockup periods end, and employ strategies to mitigate risk during these times.

Step #3: Wait For the Right Time to Buy

Dive in once the IPO shares are available and you’ve determined it’s the right time to buy. Lean on your investment strategy to determine the best time to buy shares. 

Because of the heightened volatility associated with IPOs, investors with a moderate tolerance for risk who want to try their hand at IPOs should wait a few sessions for a trend to emerge after the shares become public. 

Step #4: Protect Yourself

Finally, it’s important to set a stop-loss to protect yourself in case the IPO flops. The best way to do so is with a trailing stop-loss order, or an order to sell shares if the price falls a certain dollar amount or percentage. Let your comfort with risk determine the limit to downward movement you’ll accept.  


Alternatives to IPOs (Other Ways Companies Can Raise Funds)

An IPO isn’t the only way companies raise funding. Some of the most common alternatives to IPOs include:

Direct Listing

Direct listings are like IPOs but don’t have any input from underwriters. Instead, the company makes all decisions surrounding its offering. Direct listings can be more risky to investors as company insiders, especially founders, family, and friends, often believe the company they’ve built and invested in is worth more than it actually is. 

The issuer takes on additional risk by direct listing too. The company could face trouble accessing the funding it needs or get into legal hot water if the IPO goes poorly due to inappropriate pricing or a lack of due diligence.

Dutch Auction

IPO prices aren’t set in Dutch auctions. Instead, bidders place their bids for the prices they’re willing to pay. The highest bidders are allocated their first shares, allowing supply and demand to dictate the price from the very beginning.

Dutch auctions are beneficial to companies when there’s a high level of demand for the IPO because high demand can lead to higher prices. However, if there’s not much attention on the transaction, companies may raise far less money this way than they hoped.  


Consider IPO ETFs and Mutual Funds for Exposure Without Having to Research

Investing in IPOs can be a cumbersome process. If you’re not interested in doing the research or don’t have the time, there’s another way to tap into these investments. 

Several exchange-traded funds (ETFs) and mutual funds are centered around IPO investments, giving investors the opportunity to get involved in newly public companies without having to do the daunting research that comes along with them. 

However, it’s important to remember that ETFs aren’t all equal. Some will grow faster than others, some will provide more income, and some will charge lower fees. Compare your options before blindly investing in an ETF simply because it’s IPO-centric. 


Final Word

IPOs are exciting investments that have the potential to produce substantial returns. 

However,  investing in a company that’s planning to go public requires more intense research than investing in one that has been publicly traded for years. Considering the significant risks involved, retirees and other risk-averse investors should look for other investment opportunities. 

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Joshua Rodriguez has worked in the finance and investing industry for more than a decade. In 2012, he decided he was ready to break free from the 9 to 5 rat race. By 2013, he became his own boss and hasn’t looked back since. Today, Joshua enjoys sharing his experience and expertise with up and comers to help enrich the financial lives of the masses rather than fuel the ongoing economic divide. When he’s not writing, helping up and comers in the freelance industry, and making his own investments and wise financial decisions, Joshua enjoys spending time with his wife, son, daughter, and eight large breed dogs. See what Joshua is up to by following his Twitter or contact him through his website, CNA Finance.

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