Are You In The Know About IPOs?
With cloud communications start-up Twilio Inc. (NYSE: TWLO) making its debut as a public company this week, ending the tech IPO drought, we thought now would be a good time to get rookie investors up to speed on some IPO basics.
Experienced and novice investors alike often get giddy with anticipation when a hyped-up company like Twilio are poised to sell its shares on a stock exchange in a process known as an initial public offering (IPO). For anyone considering investing in issues from companies that want to “go public,” we break down the ins and outs of an IPO.
When a private company becomes public through the first sale of its stock on a public exchange such as the NYSE or NASDAQ, it will have gone through an IPO.
Why do companies seek IPOs?
- Raise additional capital for growth.
- Purchase assets.
- Liquefy shareholders, such as early investors and employees.
- Provide dividends to investors.
- Secure public stature to drive awareness, and recruit top talent.
Private firms typically sell only a small stake – usually between 5 and 20 percent – in their companies in the form of new shares to public investors in an IPO. For example, Google offered 7.2 percent in 2004, LinkedIn Corp (NYSE: LNKD) sold 8.3 percent in 2011, and Alibaba Group Holding LTD (NYSE: BABA) sold roughly 13 percent in 2014.
Breaking down the IPO process
There are many steps to going public. One of the key initial steps is securing an underwriter, such as an investment bank like JPMorgan, to help gauge interest and prepare a preliminary prospectus. A prospectus is a legal document that contains thorough details about a company’s business, risks, financials, number of shares being issued and its offer price.
Once the final IPO offer price is determined, the underwriter prepares a final prospectus which is filed with the Securities and Exchange Commission (SEC).
After the SEC grants approval for the prospectus following a review, a date is set for the IPO. Private companies then also typically go on a roadshow to raise interest, meeting with large institutional investors. Then, investors place their orders with the underwriters and wait to receive their allocation.
Popular IPOs can be oversubscribed, meaning there is more demand for shares than the number available in the offering. For example, Alibaba’s IPO was estimated to be about 14 times oversubscribed.
Can the little guy get in on the IPO action?
Generally, the bulk of IPO shares are allocated to institutional investors such as large mutual funds, index funds, and hedge funds. When demand is high, even these large investors may be allocated fewer shares than they ordered.
Source: Graphiq, Yahoo Finance
Most of the time, retail investors are unable to purchase shares until after the stock starts trading on the open market, often times at much less favorable prices. The graphic below illustrates a study that found investors with IPO price access outperformed those without in four out of five years. To reap the gains shown here, you would have needed purchase the IPO before it starts trading. The good news is that Motif and more online brokerages are starting to offer IPO shares to retail investors.
What you should know before investing in an IPO
Inexperienced investors may think that every IPO is worth buying in order to make a quick buck on a price pop. That doesn’t always happen, however. If underwriters overvalue their clients’ business, for instance, investors can lose significantly. Investors who get too caught up in the hype without conducting research may face downside risks.
IPOs can be an exciting way to invest, however, if you make educated decisions. Here are several factors to take into consideration before investing in an IPO.
- Read the prospectus thoroughly, but don’t rely on it alone. The prospectus is the main “research report” available to help you make an educated decision about participating in an IPO. But remember, the financial data that’s included is historical and stocks tend to trade on future growth and earnings expectations. Company management may also be incentivized to hard sell and over-promise on their earnings estimates. It’s worth reviewing analysts’ projections with a grain of salt. No one knows for certain what the company’s revenue, operation profit, and cash flow will be in the future.
- Observe the company during the “quiet period.” Sometimes companies make slip-ups during the “quiet period” that can delay the IPO date and result in an updated prospectus. The SEC states, “…a quiet period extends from the time a company files a registration statement with the SEC until SEC staff declare the registration statement ‘effective.’ During that period, the federal securities laws limit what information a company and related parties can release to the public. The failure to comply with these restrictions generally is referred to as ‘gun-jumping.’"
Alphabet Inc (NASDAQ: GOOG), Salesforce.com, inc. (NYSE: CRM), Match Group Inc (NASDAQ: MTCH), and Groupon Inc (NASDAQ: GRPN) are just a few examples of companies that took heat when information was released during their pre-IPO quiet periods. It’s good practice to re-read the latest prospectus before a company’s IPO in case any new information has been disclosed.
- Gauge demand. If a deal is oversubscribed – meaning there is more demand than shares available – there can be a higher chance the stock could pop on the first day of trading compared to one that is undersubscribed. When demand is neutral or low, flat or declining pricing is more common when trading starts. Pay attention to what analysts and the media are saying about the deal and remember nothing is guaranteed.
- Observe the number of secondary shares being sold. Existing shares held by company management, employees, and private investors are known as secondary shares. If the company is selling a lot of secondary shares, take caution. Why should you be buying if they are selling? Typically, if management is not selling secondary shares, it can signal they believe in the company’s long-term prospects and want to keep as much skin in the game as possible.
- Look out for lockups. Secondary shareholders typically have a six to 12-month lockup period after the IPO that restricts them from selling any shares during that period. In general, a longer lockup period gives the market time for outside investors to demonstrate what they believe a stock is worth based on publicly available information. If inside investors sell right after an IPO, selling pressure could conceal what the market really thinks the stock is worth. Find out what the lockup period is of any IPO you’re participating in and mark your calendar. It can be insightful to examine the trading volume and share price as the lockup approaches and after it is lifted.
Investing in an IPO is subject to unique risks, tolerance for volatility, and potential loss of principal, that customers should be aware of prior to making an investment decision. Motif cannot guarantee the availability of IPO shares for customers, who submit conditional orders as the number of shares available for distribution may exceed the supply. There are risks associated with investing in an initial public offering, and as such, they may not be appropriate for every investor. As with all of your investments through Motif, you must make your own determination of whether an investment in an IPO offering is consistent with your investment objectives and risk tolerance. Performance returns, including 1-month Return/Return Since Inception/1-year returns indicates the performance of this particular motif over that stated period of time as of the date provided. Performance is quoted for informational purposes only, however, there is no guarantee those returns will continue. See how we calculate returns. Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy. Total commission: $9.95 per motif. $4.95 per single stock. For details on fees and commissions, please click here.
© 2017 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.