What is an Initial Public Offering (IPO) and How to Invest: The Definitive Guide

Investing
Updated: 30th Jun 2020
Written by Drew Cheneler
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An initial public offering (IPO), is when a private company becomes a public company and is listed on the NYSE, NASDAQ, or any foreign stock exchange.Whether you just started investing or are a seasoned investor, you probably heard multiple CNBC news anchors talk about companies that are about to IPO, right?

What is an Initial Public Offering (IPO)?

Think of an initial public offering (IPO) like popping a fresh bottle of champagne! Wall Street drools over initial public offerings, because it is often the first time a private company with serious potential can show the world what they are made of. The company is finally selling stock shares to outside investors. That’s right, investors like you and I!

However, to the common investor, an initial public offering may seem like a simple process, but in reality, it is a highly anticipated event that requires time, effort, and a ton of strategy which all takes place behind the scenes. After reading this, you will fully understand the science behind an IPO, and as a member of this community this is paramount to our success as an investor. You will know exactly what to look for which in return will outline the RISKS associated with investing in an IPO.

Why Does a Private Company want to go public?

Up until this point, the company was being funded entirely from venture capitalists, private investors, or institutional investors. However, there is a point where a company needs even more capital to sustain the growth they desire. And becoming a public company opens a whole new slew of capital for the management team to access.

In the business world, ‘capital’ acts just like gasoline or JP8 Jet fuel. It is what propels their operations and provides the necessary heartbeat to survive in our economy.

This growth includes funding their payroll, improving their marketing activities, expanding into Europe or Asia, increasing business partnerships, and furthering their research and development on how to better improve their product.

Ultimately, as an investor, we can only hope the company has the necessary strategic outlook, leadership, and goals that warrants our hard-earned money. But do not worry, we are going to teach you exactly what to look for before you begin to consider investing in an initial public offering.

Below is a quick graph from Statista showing the amount of companies going public from 1999 – 2019. As you can see, the IPO market varies due to the strength of the economy and investor interest.

IPO Statistics - How Many Companies IPO

Source: Statista.com

Initial Public Offering (IPO) Process: How Does a Company Go Public?

To begin the IPO process, a company will immediately partner with a large investment bank or multiple banks. I am not talking about your local bank, but rather the Titans on Wall Street: Goldman Sachs, JP Morgan, Morgan Stanley, Capital One. Once the company carefully vets each opportunity, they will decide who to partner with.

This partnership will begin immediately with a stern negotiation. After all, the bank needs to make money and have skin in the game. Traditionally, the bank will agree to buy a specific number of shares from the company before they go public. Why? The bank is hoping to buy shares at a cheaper price then what it will be offered to the public. This is how those genius investment bankers turn a profit and cash in. After the private company forms a strategic partnership, they will then begin the underwriting process.

The Underwriting Process for an IPO

From this point forward, the bank will do all the underwriting for the company and begin with the SEC filings. Underwriting is a complex process, but it involves providing the U.S. Securities and Exchange Commission (SEC) with a prospectus. This is a formal legal document that is intended to help investors make an informed decision before they invest in an initial public offering.

What is included in the prospectus (6 Steps):

(1.) A thorough summary of the company going public. This includes general background information about the product they offer, their operations, and financial information. Of course, as an investor we are mostly concerned with the financial information, which will reveal to us if the company is profitable, burns cash, or taking on an immense amount of debt. I cannot reiterate this enough, BUT these are absolutely crucial to understand before we decide to employ our capital and invest in an IPO.

(2.) Of course, the NAME of the company.

(3.) The financial institutions who performed the underwriting.

(4.) The specific number of shares being offered.

(5.) What Securities they are offering investors. This can include common stock, mutual funds, notes, bonds, ect.

(6.) How the company plans to spend the raised money. This gives investors and inside perspective on the company’s priorities, ambitions, and strategic goals.

Initial Public Offering: A glorious Road Tour

However, aside from generating the prospectus, the Investment Bank will typically complete a road tour with the company they are bringing public. A road tour? Yes, a road tour! The company and their investment bank will travel throughout the country speaking to potential investors, while simultaneously showing off their hot product.

Here is where it gets a bit sneaky though, this is a chance for the investment bank to gauge investor interest firsthand. This may be the most important part of this convoluted process, because investor interest will dictate what they open the stock price at when they finally go public.

What happens after a company goes public?

After a company goes public, they are now liable to the shareholders. Investors want to know the in’s and outs of their finances quarterly, how the company is spending money, and if they are profitable. Furthermore, the company is now subject to all SEC regulatory and compliance guidelines. Mind you, these regulatory requirements are incredibly strict and serve to protect the interest of investors.

Should I invest in an IPO? 3 Tips to follow before you invest in an IPO

Investing in an IPO can either be incredibly lucrative or incredibly risky. Before you begin, follow our three actionable tips:

1. Conduct Your Own Research

This is the most important part, and it is hard to do. Private companies are not scrutinized by analyst over their financials before they are listed. This makes finding valuable data tough before a company goes public. Scavenge the internet. You need to find news articles, press releases, or any financial information if it is available. We can’t recommend Morninstar enough. They offer the best research platform to identify profitable investment opportunities. But in reality, there are plenty of resources to help you conduct thorough market research.

You need to paint a picture for how the industry currently is. Who are their competitors? Any and all information should be welcomed in your research, because you are trying to make an informed investment decision. And if this research leads to you not investing in that specific IPO, then that is also a victory. You protected your most precious asset, your cash.

2. Only Allocate about 1.0% of your portfolio to an IPO Position

You need to understand the risk associated with investing in an IPO. Hopefully your research reaffirmed your belief that it will be a worthwhile investment, or on the other hand, protected your capital. Sadly, no one knows if the stock price is immediately going to skyrocket higher or absolutely tank like Uber and Lyft did when they were listed earlier this year.

Allocating 1-2% of your portfolio minimizes your exposure. If the stock price decides it wants to head higher, than you can decide if you want to add more capital or not. Just recognize that you need to protect yourself first and foremost.

3. Wait for the lockup period to expire

The ‘lockup’ period is a legal contract between the Investment Bank and Company, which serves to protect investors and prohibits either one to cash in immediately. During the lockup period, neither side can sell their shares. Again, this is crucial to pay attention to, because when insiders begin to sell, it is usually a sign that they do not have strong faith in the future of the company. I personally do not invest in an IPO until the lockup period expires. Sure, I missed out on some serious profits when Apple, Facebook, Amazon, or Google were listed. But I also avoided investing in Lyft or Uber, which tanked on their first day of being listed.

How to invest in an IPO?

Over time, both the Investment Bank and Company intending to go public should release additional information for prospective investors. Once this information is released, then you will know the official date the company will be listed on the U.S. Stock Market. You can only buy shares of the company once it is listed on the market, so make sure you are routinely checking their website or an upcoming IPO calendar.

New to investing? Don’t worry, check out our other in-depth article about the best online brokerages.

Drew Cheneler
Drew Cheneler
Drew is a recognized Credit, Small Business, and Personal Finance Expert. He has been quoted in CNBC, The Huffington Post, Business.com, Moneyunder30, and more. He is known for breaking down complex personal finance topics into action-oriented advice, so you can make the most of your hard-earned money.