The volume and value of IPOs has experienced significant growth. What is an IPO, and how can investors take advantage of this form of investment?
Over the past few years, the number of private companies going public through initial public offerings (IPOs) has skyrocketed.
In 2020, global IPO hit its highest point in a decade, according to research by Baker McKenzie, with US$331 billion raised across 1,591 listings — up 42 percent over 2019. The law firm noted that the growth in IPO volume and value for the year was spurred on by “a continuing trend toward mega deals (valued at over USD 1 billion) driven by Chinese and US companies.”
The financials and technology industries top the list in terms of both volume and capital raise. Three of the biggest IPOs for 2020 included Airbnb (NASDAQ:ABNB) for US$3.49 billion, Doordash (NYSE:DASH) for US$3.37 billion and cloud-based data warehousing company Snowflake (NYSE:SNOW) for US$3.9 billion.
These billion-dollar capital raises may have investors wondering, what is an IPO? And why and how to participate in an IPO? Here, the Investing News Network provides those answers and more.
What is an initial public offering?
An initial public offering, or IPO, is the process by which a private company transitions to a public entity and begins to sell shares of stock to the public. This process is also known as “going public.” Companies use them to raise capital, pay off debt or even provide an exit strategy for the company’s founders and early investors.
According to Investopedia, there are two main stages in the IPO process: the pre-marketing phase and the initial public offering itself. During the pre-marketing phase, the company will advertise its intentions to list on a stock exchange and solicit private bids from underwriters. The role of the underwriters is to manage every part of the IPO process, including due diligence, document preparation, filing, marketing and issuance.
Once the underwriters for the IPO are chosen and the underwriter agreement is in place, the IPO team — comprised of underwriters, lawyers, certified public accountants and securities exchange experts — begins compiling the required documentation to present to the exchange on which the company intends to list.
During this stage, marketing materials are created that will help the underwriters determine public interest to better gauge the offering price and issuance date for the IPO shares. The company will take steps to form a board of directors and ensure processes are in place for quarterly financial and accounting reports to stay compliant with exchange regulations.
On the day of the IPO launch when the first shares are issued, Investopedia states, “Capital from the primary issuance to shareholders is received as cash and recorded as stockholders’ equity on the balance sheet.” And with that, a privately-owned company transforms into a publicly-traded entity with grander access to capital, greater ability to grow and increased credibility for future loans.
Why participate in an initial public offering?
IPOs are clearly advantageous for companies, but what about the investors who participate in them? What can investors gain (besides shares) in participating in an IPO?
One of the investor advantages of IPO investing is the opportunity to get in on the ground floor at the offering price before it starts trading on the open market. Getting in early in the life cycle of a public company provides investors with the opportunity to profit from the company’s potential future growth.
“IPOs are usually discounted to ensure sales, which makes them even more attractive, especially when they generate a lot of buyers from the primary issuance,” explains Investopedia.
However, as is the case with any speculative investment, IPOs are not without its risks. For one, there is no guarantee that a stock will go on to trade higher that or even at the initial IPO price. Another factor to consider is when you invest. The number of investors who can get in at the initial offering price are limited. Once the stock begins trading on the open market, the share price can swing widely.
For example, an investor may end up paying $40 per share for a stock that opened at $20 that same day. It’s also possible for the closing price to be well below the offering price.
Secondly, there is often limited financial data available for private companies pre-IPO. The U.S. Securities and Exchange Commission (SEC) advises that investors read the IPO prospectus (the offering document that provides information about the company and terms of the IPO) “because it provides information regarding the terms of the securities being offered as well as disclosure regarding the company’s business, financial condition, management and other matters that are key to deciding whether the offering is a good investment.”
Investors should also take a look at the management team as well as the quality of the underwriters as part of their due diligence.
How to participate in an initial public offering?
For those investors who have ignored the hype, studied the company for themselves and have decided the potential reward is the worth the risk, there are two ways to participate in an IPO.
The first is by purchasing shares at the offering price. This is typically available to a limited pool of investors who are invited to take part in the IPO through an underwriter. For the most part, this opportunity is usually extended to institutional investors and high net-worth individuals.
The more common entry route to an IPO is to purchase the shares through a broker once they are resold on the public market. Keep in mind that not all brokerage firms deal with IPO stock transactions. Many of the larger inexpensive brokerages do, including TD Ameritrade, Fidelity, Charles Schwab, and E*Trade.
The brokerage firms have eligibility requirements for investors looking to participate in an IPO. For example, depending on the IPO, Fidelity requires that investors have either US$100,000 or US$500,000 in household assets (excludes institutional or annuity assets, such as 401(k), 403(b), and annuity contracts), or be a premium or private client group customer.
Once an investor has met the eligibility requirements to participate in the IPO, the next step is to determine how many shares to purchase and at what price. The broker will confirm this with the investor the night before the IPO launch and the investor will be given a deadline to place an order.
One final note on IPOs
While IPOs represent an exciting opportunity to gain exposure to an emerging growth story, they are also one of the riskiest bets in the stock market — especially compared to market tested blue-chip stocks paying dividends. Please practice due diligence and assess your own risk profile before investing in an IPO.
This is an updated version of an article first published by the Investing News Network in 2016.
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Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.