Hopefully one day if you’re an entrepreneur, you will build your company into a successful brand that can be publicly traded on a stock market. Essentially that is what an IPO, or Initial Public Offering, is. It is the process where a privately held company becomes a publicly traded company with the initial sale of its stock. Even after an IPO, publicly traded companies can revert back to being private entities if they so choose.
An IPO is a tool that companies use to secure capital through investments for future use. In most instances, this investment is used to expand or improve their business, purchase assets, or provide a dividend to investors. Once a company has decided to have an Initial Public Offering, there are a number of steps involved.
The first step is usually securing an underwriter. An underwriter is usually a bank, or multiple banks, that help the company put together their prospectus. Underwriters are also in charge of getting the security out to the public. The prospectus is actually written twice, an initial prospectus and a final prospectus. The initial prospectus is often referred to as a red herring. The red herring usually lists secondary information about the company, but not important info like IPO stock share price and the number of shares available.
The red herring is similar to an annual report with financial data and company information. It’s often used as a tool to determine an IPO stock share price, with the hopes that the information provided will generate interest in the company. Underwriters work with the companies to set the initial IPO stock share price based on this interest, and if there isn’t much interest, that usually leads to a lower IPO price. Underwriters and companies can also misinterpret the interest leading to “IPO failures” where the company didn’t raise the capital they expected.
Once the final prospectus is filed with the Securities and Exchange Commissions, the company and underwriter set a date for the Initial Public Offering. For example, Twitter (TWTR) filed its final prospectus on October 3rd, 2013 and held its IPO on November 7th, 2013.
Then, the IPO occurs. Typically, heavy hitters within the investment community will be afforded the opportunity to purchase the IPO company’s stock within the IPO price range early that trading day. Later, on the same day of the IPO, the general public is afforded the opportunity to purchase the stock, but often at a substantially greater price. However, sometimes a stock price will plummet on its IPO day, which typically shows that the underwriters overvalued the company.
One question that might arise then is, “If an IPO is going to likely be substantially higher or maybe lower than the projected price when I can buy it, why should I invest in an IPO”? To best answer this question you have to assess your investment goals and strategies. For example, some may consider investing in an IPO with a price lower than expected as a good idea. Others might see it as a misunderstanding of the market by the specific company involved and shy away from the stock. Some make money on this strategy, while others later realize there were reasons behind the company’s poor performance.
However, it’s more common that an IPO stock price soars on its opening. In this case, it’s important to consider your long term goals. Can you afford to spend $50 per stock share on a stock that might be $25 in two weeks, but could be $150 in two years? Those who bought Facebook (FB) on its IPO and remained long in the stock have been rewarded for their patience. Those who bought Twitter on its IPO would’ve been better off shorting the stock.
Generally, over the first six months a company is traded on the stock market, its stock price bounces all over the place, so patience is required with IPO investing. Some advise waiting out this six month period for a stock to settle into the market before considering any investment strategy. Either way it is likely best not to day trade on an IPO within the first six months on the market, as the price will fluctuate based on every bit of news that comes out about the company.
Investing in an Initial Public Offering is often what investors might do in order to say they have been an investor of the company “from the beginning.”
