While initial public offerings (IPOs) are an attention grabber, with investors expecting substantial price increases once they go public, it’s important to know that investing in IPOs can be risky as they may provide returns of varying amounts in the long run.
Here’s what you need to know about IPOs, including their purpose, their use to special purpose acquisition companies (SPACs), and how to invest in one.
IPO Explained
An IPO is an event or process where a private company sells its shares to the general public for the first time. The newly-issued shares are listed on a stock exchange of the firm’s choosing. An IPO is usually called “going public” or “floating.”
Companies perform an IPO for different reasons. For example, a firm may go public so its current investors, including the owners and employees, can sell some of their shares. An IPO can also provide backers, like private equity companies, the opportunity to cash out their investments.
In addition, companies may go through such a process to generate additional funds that would allow them to expand, acquire businesses, or cut back debt.
By floating, companies can improve their public business profile and obtain ideal or better terms when they’re trying to borrow funds. However, taking such a step also exposes them to further scrutiny and more regulations like disclosure requirements, including filing quarterly and annual earnings reports.
They will also need to have the approval of their shareholders when performing corporate activities, such as determining executive pay, proposed disposals, or acquisition considerations.
An IPO price is set clearly to ensure complete subscriptions to newly issued shares and to provide a share price increase to investors as a reward during the stock’s trading debut.
In an IPO, major shareholders and current investors must follow a lock-up period. Once the company is public, investors are not allowed to sell their shares for a specified time, which usually lasts 90 to 180 days. That way, they can support the share price in its first days in the market.
Purpose of an IPO
While an IPO marks the general public’s first purchase of a company’s shares, it’s important to note that flotation is done to let the firm’s original investors sell their investments.
To a company’s life cycle, an IPO is the end of one phase and the starting point of a new stage, and many of the initial investors would look to sell their holdings in a new business or startup.
On the other hand, investors in a well-known private firm that is preparing for a public listing may seek a sale of some or all of their shares.
In an IPO, there’s a round for family and friends, but angel investors are the early birds that catch the worm. Before the company goes public, a considerable amount of private money, such as Shark Tank-type of money, has already been put into it.
A private business can also undergo flotation to raise extra capital. Selling shares to the public can help a company gain proceeds, which can be used for business expansion, research and development, or debt payments.
Important IPO Terms
IPOs have their own terms that you need to remember and understand should you decide to participate in one:
- Common Stock
Companies sell shares of common stock when going public. A common stock represents a unit of ownership in a publicly-traded firm. Such a stock makes holders eligible to vote on company matters, appoint the board of directors, and receive dividends.
- Issue Price
Also known as the offering price, the issue price of an IPO is the price at which the company sells the shares of common stock before it starts trading on a public exchange.
- Lot Size
The lot size is the minimum number of shares you can bid for in a flotation. You need to bid in multiples of the lot size if you’re looking to bid for more shares.
- Preliminary Prospectus
A preliminary prospectus, commonly known as a “red herring,” is a registration statement filed by the company looking to go public. This document contains information about the firm’s business, strategy, past financial statements, latest financial results, and management.
- Price Band
A price band represents the range in which investors can bid IPO shares, established by the company and the underwriter. The price band of institutional investors can be different from retail investors.
- Underwriter
IPO underwriters are usually financial experts or investment banks that handle the issuing company’s offering. They’re also responsible for setting the original offering price, announcing the flotation, and assigning shares to investors.
SPACs Explained
In recent years, we have seen more and more of SPACs or blank check companies. A SPAC is a shell firm created to raise capital during an IPO so it can buy or merge with an existing business.
Several famous investors use their reputations to set up SPACs to raise money and acquire other companies.
However, SPAC investors are only sometimes informed about the firms that the blank check company plans to buy. Some specify the types of companies they want to acquire, while others are not given any information.
SPACs have risen in recent years because private companies found that being bought by a SPAC is an easier and faster way to list on exchanges. Being an entirely new firm, a SPAC often has little financial history to present to the Securities Exchange Commission (SEC).
Moreover, many investors of SPAC can get their money back in full if the blank check company fails to buy the firm within 24 months.
Buying IPO Stocks
Buying IPO stocks can be tricky and different from placing an order for a specific number of shares. To acquire one, you’ll need the help of a broker managing IPO orders.
An IPO stock is typically purchased via a stock broker or, occasionally, directly from the underwriter. The other option can work if you have connections with the people working at the company or the investment bank.
Certain brokers can offer you access to IPOs. However, in firms, you must first meet eligibility requirements, like a minimum account value or a particular number of trades made within a specific time.
Furthermore, while your broker can help you access an IPO and you pass the eligibility review, you may still end up not buying the shares at the issue price. Retail investors often cannot get hold of shares during the IPO stock’s first day of trading.
By the time they can purchase, the price might already be significantly higher than the initial offering price. Therefore, if you, for instance, bought a stock for $30 per share that opened at $15, you’re missing out on reaping huge early gains.
To solve this, some trading platforms have allowed retail investors to access shares of certain IPO firms at the issue price. Still, it’s important that you do your research before putting your money into a company at its IPO.
