“IPO” stands for Initial Public Offering; the point at which a company makes their stocks available to investors on a public exchange for the first time. Investing in an IPO offers the opportunity to invest in stocks that have the potential to rise quickly in value, but can also carry a high level of risk, so investors should consider the strategy carefully.
At its most basic level, an IPO is when a private company goes public. It could be a new company, or one that is long-established, but has never offered shares to the public before. Here, we will discuss how an IPO works and what investors should consider when investing in one.
What is an initial public offering (IPO)?
An IPO, or Initial Public Offering, is used when a company makes their stock available on a public exchange for the first time. Any type of company in any industry can launch an IPO, but the process mainly applies to a growing company that is looking for an injection of investor cash to fund its future plans.
A company will launch an IPO to raise funds, and it can generate a large amount of capital by doing so. For example, one of the most successful IPOs in history was the $22 billion raised by Alibaba when it joined the New York Stock Exchange in 2014.
What does an IPO mean for investors?
An IPO offers investors something fresh in the market. It presents the opportunity for a price-effective investment in a small company with high growth potential, or in an existing company with a proven track record. The price per security issued will be clearly stated in the IPO order document, and is usually fairly affordable for all investors.
Patience can be a virtue for investors considering an IPO. Sometimes, the initial price will correct after the initial hype, as some investors seek to “sell the news.” This can present more attractive buy-in opportunities down the line, as the IPO stabilises in price.
On the other hand, with limited market history to draw technical analysis from, it can be hard to ascertain the fair market value of the company issuing an IPO. This can lead to initial price volatility, and even the most popular companies can fall in price once the stock goes public.
Furthermore, companies that issue an IPO will likely not have as much liquidity as more established companies. This can imply lesser ability to pay debt obligations or liabilities, increasing the potential risk attached to companies that have recently launched an IPO.
Tip: Generally speaking, IPOs are considered fairly high-risk investments.
How does an IPO work?
The IPO process starts when the issuing company asks an investment bank to analyse the market conditions for them. This means discovering the appetite for new IPO stocks in their industry, and determining what a fair market value might be.
Once this is done, the company will need to draw up a prospectus for potential investors and get approval from the exchange they want to join, as well as the relevant regulatory authorities.
The pre-marketing stage can see companies sell stock to institutions, which underwrite a large chunk of the IPO, and receive a discounted price in exchange.
On the day that the shares go public, they become ordinary stock that can be traded in the usual way.
How to invest in an IPO
When news breaks about a company considering an IPO, their stock will not yet be on the market. While investors may think this means they cannot yet purchase stock, this is not always the case.
In practice, investing is not as difficult as it may appear to be. There is a set period when the public can register their interest in an IPO stock.
At the end of this period, the company will calculate how many people have asked to buy stock, and if the offer is oversubscribed, they may give each purchaser a percentage of what they asked for.
Tip: To find inspiration, you could do an IPO search or view IPO calendars to find companies of interest.
On the day that the shares go public, retail and institutional investors can invest or trade the stock in the usual, market-ordinary way.
Investors should also bear in mind that there may be a waiting period or lock-up period involved, so it can make sense to wait until the insiders sell their shares before investing.
What are the benefits and drawbacks to companies?
While an IPO can bring considerable benefits to companies, it can also present significant drawbacks. It is important to understand why a company might seek to launch an IPO, and understand the potential implications the process might have on them.
- IPOs are a way for companies to quickly raise a large amount of capital from public investors.
- Public funding may provide company founders with an exit strategy that rewards them for their work and early investment.
- An IPO might make it easier for companies to gain additional credit, as a public firm will typically have more transparent processes and figures.
- Running an IPO can be extremely expensive, with underwriting fees of up to 7% of the gross proceeds.
- Given the time that it takes to complete the IPO process, it can distract the company from their main business operations for a prolonged period of time.
- IPO regulations may force companies to reveal business practices and ideas that they would rather keep confidential. It can subject them to intense public scrutiny.
Important considerations before participating in an IPO
Investors should thoroughly research a company before investing in its IPO, paying particular attention to some of the key tools and indicators that offer well-rounded analysis in spite of limited market history.
The name of the IPO underwriter should be of particular interest to investors, as the link between IPOs and underwriter reputation is generally a solid indicator of the extent to which the IPO will be a success.
An IPO prospectus is another tool investors can use to see more than just the IPO share price. This document offers insights into a company’s overall vision, and details who its executive leaders are.
Summary
IPOs are an important element of the stock market, and can present fresh opportunities to invest in new companies at a relatively low price. There is always a degree of uncertainty around IPOs, however, and investors should remain cautious and not simply assume that any IPO is going to be a profitable investment.
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FAQs
- Can I lose money when participating in an IPO?
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Yes, just as when investing in any stock, there is a probability of losing money when participating in an IPO. Investing in IPOs bears high risk, as the difficulties in accurately assessing and valuing a company may result in the initial price being too high, and thereby falling to a lower value than you paid for it.
- What is over-allotment?
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Over-allotment refers to the option which allows underwriters to sell more shares than initially planned in an IPO. This can also be known as a “greenshoe” option. Usually, underwriters are allowed to sell up to 15% more shares than the original amount issued. This option offers some degree of flexibility in terms of setting the final size of the offer, as the demand can be hard to predict.
- Are stocks the only assets that could go through IPOs?
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While shares of a company are the most common assets to go through IPOs, cryptoassets can also become available to the public in a similar way. When a new cryptoasset is launched to the public, it’s called an ICO, (Initial Coin Offering). Examples of successful ICOs include the launch of Block.One, which raised $4 billion.
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eToro is a multi-asset investment platform. The value of your investments may go up or down. Your capital is at risk.
This communication is for information and education purposes only and should not be taken as investment advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without taking into account any particular recipient’s investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.