An IPO, or initial public offering, or stock market launch (whatever you’d like to call it) is the very first sale of stock issued by a formerly private company to the public.
An IPO is completely different from a private company, which has a bit more freedom than a public company, as a public company is required to comply with Securities and Exchange Commission (SEC) reporting guidelines.
Why does a company go public?
There are some complicated reasons why any company goes public, and there’s also a very simple reason: Many private companies realize they need more money than what their initial stakeholders can provide.
Several other reasons for going public include “maximizing shareholder value,” raising capital to invest, or, possibly, using the shares as currency for a merger or acquisition.
IPOs are also one of many ways venture capitalists and private equity investors, as well as other early investors (such as Mom, Dad and Uncle Bob) that founded the company in the first place can take their opportunity to exit their stakes in the company.
How a company becomes publicly traded
A company becomes publicly traded after a lengthy (and expensive) process. Let’s say you own a company (you’ll generally need around a total of $10 million in earnings over the three years prior to the IPO, by the way) that you’d like to be publicly traded.
You must appoint an underwriter, typically an investment bank, broker-dealer or a group of broker-dealers, to take on legal responsibility for the shares of the company.
An attorney or team of attorneys will need to be put in place, as well as an auditor, for whom you will provide financial information about your company. You’ll also need to file an SEC Registration Statement, for which you will need to provide comprehensive information about your company.
In order to become publicly traded, your company:
- Falls under the guidelines of the SEC
- Will need to disclose financial status/statements on a regular basis
- Will be watched by the SEC on trading practices
- Will need to hold shareholder meetings
How stock prices are determined
Market demand will determine IPO stock prices, and all of this is determined based on surveys done among investors by the company’s underwriter.
If members of the public are super-excited about a new IPO, they can actually push the share price higher than the stock’s book value. However, as an investor, it’ll be up to you to be savvy enough to calculate whether a particular IPO’s shares are accurately priced.
To do that, take the following steps:
- Get a hold of the company’s prospectus (you can contact the underwriter of the IPO).
- Locate the number of shares the company has sold.
- Divide the number of shares sold by the amount of money the company has received from its IPO stock to get the value of one share.
- Finally, know enough about the company to determine whether you believe that share price is reasonable depending on the valuation of the company. An accurate valuation would use factors such as the company’s management, capital structure, the prospect of future earnings and takes into account all assets that the company holds.
How do I invest in an IPO?
Above all else, as an investor looking into an IPO, it’s vital that you understand the process, from underwriting to the actual selling of stock. A lot of IPOs crash and burn, or at least, a great number of them initially underperform in the market.
That’s why it’s vitally important that you know and understand the process so your savings doesn’t go down with it. (There’s a reason Warren Buffett calls IPOs “a stupid game.”) Discount brokers offer investors the option to invest in IPOs.
For example, TD Ameritrade outlines its eligibility requirements and how to fund your account. You must have at least $250,000 in an account with TD Ameritrade or have completed 30 trades in the last three months, in addition to submitting an IPO Eligibility Form through FINRA.
It’s a fairly straightforward process to fund your account; it’s done via a wire transfer and can be used to purchase IPO stocks three business days after the deposit settlement date. This is the information for TD Ameritrade; other discount brokers may have different eligibility requirements and processes.
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Should I invest in an IPO?
In many cases, it may a good idea to wait until after a stock starts trading—in other words, let the dust settle.
The days, weeks, and months following an IPO will typically reveal whether it was priced well and what kind of growth prospects might lie ahead. Some simple trading logic can be built around an IPO.
Investors can simply wait for a day, or a few days, after the IPO, and can then determine potential entry and exit points based on their observations and understanding of technical analysis, as well as what’s appropriate for their risk tolerance.
IPO words to know
- Book building process: A systematic process of determining investor demand for shares during an IPO.
- Follow on public offering (FPO): Issuance of brand new shares by a public company listed on a stock market exchange.
- Fast track issue: A faster and more cost effective method of raising capital by listed companies.
- Preferential issue: A private placement of securities by a listed company.
- Direct public offering (DPO): Companies can avoid the costs of having to finance an underwriter by doing a DPO instead of an IPO, as it allows the company to sell stock directly to investors without the underwriter involved.
One of the most important aspects of an IPO is the opening price—where the stock begins its exchange-listed life on its first day of trading.
Accurately pricing an IPO is a challenge even for the investment banks that have been doing this for years. Naturally, the company holding the IPO wants a high price, while investors prefer something lower. It’s up to the banks to find the middle ground. Sometimes they nail it and sometimes they miss, badly.
Ultimately, not all IPOs initially fly like Twitter, LinkedIn, and Google, so do careful research to determine which IPO will be a Google-like success.