What Is an IPO and How to Invest in One (6 Scenarios)

Updated on April 4, 2018
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Daniel is a retired business executive who now devotes most of his free time to trading stocks and stock options in the stock market.

Should You Invest in an Initial Public Offering?

Planning to invest in an IPO? You need to know what you are getting yourself into. To best understand what an IPO is let us first define the term.

IPO stands for Initial Public Offering. It is that time in the life of a new company when its shares of stock are offered to the general public via listings in the various stock exchanges through the services of stockbrokers.

Here is what Warren Buffet says about investing in one: “IPO investing is a stupid game and investors are better off staying away from them than investing in them.”

“IPO investing is a stupid game and investors are better off staying away from them than investing in them”.

— Warren Buffet

The general consensus in the stock market supports this statement and says that the average stock investor should stay away from IPO offerings.

So why is there so much excitement whenever a stock goes IPO? Why do so many in the stock investing public go crazy in wanting to get in on the game?

I don’t claim to be an expert in the field of IPO investing but I know enough to offer an answer to these question by showing examples of various scenarios (six of them) that illustrate what could happen to an investment in IPOs over the short term and long term.

Before going into the meat of this article, let me first give readers who may be somewhat in the dark as to what IPOs are and how they come into being. The following chronology of events in the life of a newly formed company will give readers a good idea of how this creature called IPO is born and nurtured.

The Birth of a Company

In its very early beginnings or in its infancy, a business may start with perhaps only a concept in the mind of the creator. It could be a new product invention or a newly conceived service scheme. The creator/originator then transforms his concept into a material being by forming a business to promote and sell his creation to the outside world.

In most situations, the creator/originator does not possess all the necessary resources and qualifications needed to get the business off the ground. Financing, marketing know-how, legal requirements and manufacturing competence are just a few of the essentials required for a new business. Partners may be called in to provide these requirements.

This first group of investors/partners is what is better referred to as the founders of the newly formed business enterprise. Most, if not all, of these founders invest their own money to fund the venture in its first attempts to break into the market. As the business grows, there comes a time when the founders are faced with the need for infusion of more capital to finance continued growth of the infant company.

After exhausting their own, family and friends’ personal funds as well as outside loans, the company’s financial resources may no longer be enough to support the company’s ambitious projects. It may have reached a point where a large infusion of capital is required to keep its growth momentum.

Angel Investors (Outside Investors) and Venture Capital Firms

This is the time when the founders may turn to outside investors by inviting angel investors or venture capital firms to infuse the required funding. An angel investor is a wealthy private individual or a group of wealthy individuals who invest in a start-up or young company with the objective of assisting the company in realizing its business objectives and hopefully cashing in hefty profits from its success.

A venture capital firm is very much similar to an angel investor. Venture capital firms are usually corporate firms with its own set of shareholders or partners whose main purpose is to invest seed money or additional funding into promising new businesses. It seeks to grow a young company into a position of financial strength and such high value that it can eventually be offered to the general public as a company with a very promising profitable future. This is the venture capital firm’s ultimate goal. To sell the company’s shares to the general public at a much higher price than they paid and this is accomplished through an Initial Public Offering of shares.

Why Does a Company Need to Go Public?

There are three main reasons a private company would want to offer its shares to the public and thus become a public corporation. First and foremost is that a public offering enables a company to reach an enormously wide capital base for raising additional equity funding.

Another reason may be that the original founders together with angel investors and/or venture capitalists would want to add value to their shares via a public offering. An initial public offering, or IPO, becomes a de facto public auction of shares when listed in a stock exchange. In almost all cases the stock price is frenziedly bid up by anxious buyers who believe they are getting in at the ground level of a promising new corporation.

A third reason of is that an IPO makes it easier for company founders and subsequent equity investors to trade their shares in the open market.

What Is the Process Involved in an Initial Public Offering?

The first step is to appoint a manager to undertake the long and costly process of going through all the legalities of obtaining approvals to offer company shares to the investing public. This is where investment banks come into play.

The appointed investment bank or a consortium of investment banks will underwrite the IPO process. By this is meant they accept to take on total responsibility for all actions necessary to bring the company through all the phases of the IPO process. This includes absorbing all the expenses and costs involved which can be quite substantial in the very long course of getting to its main objective of a public offering.

Among other things they take care of preparing the all-important document/brochure called a “prospectus”. This pamphlet provides investors with material information such as a description of the company's business, financial statements, biographies of officers and directors, detailed information about their compensation, any litigation that is taking place, a list of material properties and any other material information (Wikipedia). This prospectus is distributed by the underwriting consortium and brokerage firms to potential investors.

Sample Cover of an IPO Prospectus

Source

For their services, the consortium of investment banks are guaranteed a large chunk of all the newly issued shares in the IPO. The consortium is obligated to buy all the shares that it has subscribed to purchase. The stock price is offered to the consortium at a discounted price and it is in this manner that they derive payment for their services.

The consortium can then sell their shares publicly in the stock market (on or after IPO date) at prevailing market price. It is almost certain that the publicly traded share price will be more than the subscribed price because, whether deliberately or not, pre-IPO stock is always underpriced. This has historically been the case in almost every IPO.

Example: An issuing company may price its pre-IPO stock at $10 but may offer it to the consortium at a discounted price of $8.00 or at any price below $10. On its IPO date, the stock may enter the public market at say, $15 or higher, in which case the consortium stands to make a killing on its holdings.

Who Gets to Buy Stock At Pre-IPO Price?

Unfortunately for the average stock investor, who is referred to as an outside investor, it is not easy. In fact, it’s almost impossible for the average outside investor to acquire newly issued shares at pre-IPO price.

This is what happens in an IPO offering.

After all the necessary legalities have been complied with, the issuing company and the investment bank consortium are now ready to allocate IPO shares to all interested parties at what is a pre-IPO price. A price and date is set for the release of shares to the general investing public. But prior to such date the parties holding pre-IPO shares start allotting shares to their most valued clients and friends. Most of these are institutional investors and the large stock brokers and investment houses such as Charles Schwab, Fidelity Investments, TD Ameritrade, Scottrade and many others. The recipients of pre-IPO shares that have been allotted shares in turn allocate their portions to their own most valued clients.

Who Are Valued Clients That Get Pre-IPO Shares?

Depending on which brokerage firm is used, valued clients normally fall under one or more categories. Those with accounts that have at least $250,000 or more in assets with the firm, those who have traded large blocks of stocks many times over a period of time, say 30 or more times over 12 months, or those with large stock portfolios under the brokerage firm’s direct management.

There may be other requirements demanded by each firm that a client needs to meet to qualify for the bounty. Unless an outside investor meets these requirements it will have to buy shares in the open market on the IPO date.

Contrary to Stock Market Wisdom IPOs Can Actually Be Good Investments

While most savvy stock market pundits will advise you against investing in an upcoming IPO there are situations when IPOs have been good investments. One must be aware though, that buying into an IPO stock is plain speculation. It is a bet that the company you are buying into is going to grow into such a successful venture as to enable you to reap fantastic profits later on.

Successful cases like the FANG stocks are always in mind when one thinks about reaping profits from IPOs. FANG stands for Facebook, Amazon, Netflix and Google. These companies have brought unimaginable riches to those who invested in them at their initial public offerings. Some others that have provided great returns (as of this writing) are Tesla (TSLA), Nvidia (NVDA), Shopify (SHOP), Square (SQ), Baidu (BIDU), just to name a few. Keep in mind these are rare and do not happen frequently.

On the other side of the fence there are those IPO’s that have been total disappointments to those who bought on IPO day. Comparing winners to losers there seems to be about an even number on both sides. However, over the long term there seems to be more winners than losers. Does this tell us that investing in IPOs for the long term is the way to go?

Let’s find out.

6 Scenarios of When to Invest in IPOs

I’ve looked at previous IPOs of past years and designed six different scenarios of investing in them. The six situations of when to invest and the dates of liquidation are illustrated in the following tables. My review covers randomly selected IPOs in the years 2015 and 2016, sixteen of them in all.

If I invested $5,000 in each IPO my total invested capital for the two years 2015 and 2016 would have been $80,000 ($5,000 x 16 IPOs).

Scenario 1

In the first scenario shown in Table 1, I assumed buying each stock on the first dates of IPO and selling or closing the position one week later. Of the 16 stocks I got into, 7 were winners and 9 were losers. Assuming I invested $5,000 in every stock at every IPO date, the result of one week’s holding is a small positive return in dollar terms ($85,923), despite 9 losing stocks and only 7 winners. As one can see from the table, Shopify and Fitbit were such big winners that they made up for all the losers.

Scenario 2

In the second scenario, Table 2, I bought each stock on the first dates of IPOs and sold them one month later. There were 9 winners to 7 losers, with better ending dollar values and higher percentage gain rates.

Scenario 3

Now let’s move on to scenario 3, Table 3. IPO stocks were bought on the first day and sold 6 months later. Here we find 10 winners versus only 6 losers. In this case, despite the greater number of winning positions, the ultimate result was not as good as the first two situations.

Scenario 4

In scenario 4, Table 4, the IPO stocks were held long term until March 22, 2018, the date this article was written. The earlier IPOs were held for more than two years and the later ones for more than one year.

On March 22, 2018, the portfolio of IPO stocks produced 10 winners and 6 losers resulting in a total value of $149,810. This represents a return on investment of 87% (149,810 ÷ 80,000). Not a bad return for a holding period of less than three years.

Scenario 5

Now let’s see what happens if we tweak the situation a little. Instead of buying the IPO stock on the first day of offering, let’s assume I bought each of them 1 week after each release date.

This scenario produced the most number of winners versus losers. Even if the total value was not as good as that of Scenario 4, it still returned a good ROI of 70%.

Scenario 6

In this scenario, I bought the IPO stocks one month after their release dates.

As in scenario 5 this program produced the same number of winners but the total value was even less than scenario 5.

Conclusion

Based on the numbers I’ve presented in this article is it safe to say that investing in IPOs for the long term makes good investment sense?

What the numbers are saying is that one should not invest in an IPO with the expectation of making a killing in a short period of time. But over the long term it certainly looks like IPOs are good investments.

The numbers also show that it makes sense to enter an IPO issue on the first day of release rather than wait a week or a month.

For those who believe that IPOs are speculative in nature, the numbers shown here makes it worth speculating in IPOs.

The reader must keep in mind that the stocks shown in this article were selected at random. I wonder what the numbers would show if we did the same exercise but included such heavy weights like the FANG stocks and Tesla (TSLA), Nvidia (NVDA), Shopify (SHOP), Square (SQ) and Baidu (BIDU).

I leave it up to you to draw your own conclusions.

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    © 2018 Daniel Mollat

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