The Basics Of An IPO
Investing in initial public offerings, or IPOs, has long been relegated to institutional investors and the ultra-rich. Today, individual investors can participate in IPOs. If you are interested in investing in IPOs, then you must understand the basics about the process, as well as the potential risks and rewards.
An IPO occurs when a private company sells its shares to the public and is listed on a stock exchange for the first time. Before the IPO, the company may have private investors such as angel investors or high net worth clients, but the company's shares were not available to the public. The IPO process transfers a portion of the ownership of the company to the general investing public for the first time. The company's main motivation for selling its shares is to raise capital that it can use to continue growing the company.
There are several steps that a company will navigate in the lead up to the issuance of its IPO. Working with its underwriters, the company will determine the approximate offering price and the number of shares it will sell. The company will issue both an S-1 filing and a prospectus. Both documents have important information that potential investors should read and understand. For example, the prospectus will discuss the company's overall business, potential risks to its business and its growth prospects.
The company and its underwriters will then go out on a road show. During the road show, the company will visit large institutional investors and talk to them about their company and explain why the investor should consider purchasing shares. The company will also speak with large brokerages with the hope that the brokerages will recommend the shares to their clients.
The road show also allows the company to gauge investor interest in their company's shares. If interest is strong, the company may consider increasing the proposed share price or the number of shares it offers. If interest is weak, then it may scale back the share price or quantity of shares it offers.
As the road show progresses, the company will firm up the expected date that it will start selling shares on the open market. Approximately a week before the IPO date, the company will issue a forecast of the price range and the number of shares it will sell. For example, the company may state that it will sell fifty million shares with a proposed range of $10 to $12 per share.
When the company issues this final price range, then individual investors can provide an indication of interest in the IPO shares. They can provide this indication of interest, that is, if their brokerage has been allocated shares of the IPO.
To offer shares at the IPO price, a brokerage needs to be allocated shares to sell to its clients. The vast majority of shares are allocated to the underwriting firms hired by the company, who can, in turn, sell the shares to their clients. A small number of shares are offered to other brokerage firms. For example, Fidelity may not be an underwriter on a particular IPO, but it may have access to some shares which it can sell to its clients.
If a brokerage has access to IPO shares, it allows its clients to indicate their interest in the shares. During this process, the investor will have access to all the filing and the prospectus to research the potential investment. If the investor decides to purchase shares after, hopefully, doing the proper due diligence, they will tell the brokerage the maximum number of shares they want to purchase based on the proposed price range.
There is not a guarantee that the investor will be allocated all the shares that they want to purchase. Or, for that matter, there is not a guarantee that they will be allocated any shares at all. This is especially true if the investor's brokerage is not one of the underwriters. Since a brokerage which is not an underwriter of the IPO gets allocated only a small number of shares of the IPO, the brokerage may have more demand from its clients than it has shares to allocate. If this is the case, the brokerage will only be able to allocate a small percentage of an investor's indication of interest. In some cases, an investor will not be allocated any shares at all.
Furthermore, not all investors are qualified to invest in IPOs. Most brokerages have minimum account limits. For example, a brokerage might only sell IPO shares to investors with an account balance above $500,000. Also, most brokerage only sell shares of an IPO to individuals who are experienced investors and who have the appropriate risk tolerance.
If an investor gets allocated shares of an IPO, they will pay the final price per share that the company announces on the day that the IPO starts trading. This price will typically be somewhere in the indicated price range that the company previously announced.
Before trading begins, market makers at the stock exchange will gauge the demand for the stock from investors in the open market. These market makers will price the first trade on the open exchange based on this demand. When the stock finally begins trading, supply and demand will take over and the price of the stock will rise or fall accordingly, just like any other stock that trades in the public market. No matter where the stock starts trading on the exchange, the IPO investor will pay the price set by the company.
Will the investor who purchased shares at the IPO price have a guarantee gain on their investment? Absolutely not! Many IPOs start trading, or end their first trading day, with a loss. Some others will have a fantastic first day, rising 10%, 20% or even doubling. But there are no guarantees. The market forces alone will determine whether an IPO gains or losses value once it starts trading on an exchange.
After an investor gets granted shares at the IPO price and the stock begins trading on the open market, they are allowed to sell their shares at any time. If the stock pops 20% on the first trade, they can flip their stock and pocket a quick win. There is a caveat about flipping shares. Many brokerages will look down on investors who are allocated shares at the IPO price and then sell immediately. There is nothing a brokerage can do to stop the investor from selling, but they can take this flipping into account if the investor indicates interest in a future IPO and decide not to allocate shares to them.
For many individual investors, the IPO process can often be shrouded in mystery, and they think access to IPO shares is limited to institutional investors. While getting access to shares at the IPO price can be challenging, many individual investors can participate. Although the access to IPOs is available, individual investors should enter the process with their eyes open and complete their due diligence since investing in IPOs can be risky.