IPO: how do companies appear in the market?

IPO: how do companies appear in the market?

2022-06-27 • Updated

An initial public offering (IPO) is essentially the birth of a company in its public form. It changes many things about the way that management runs the firm and can present opportunities and dangers for retail investors. IPOs are more common during bull markets and the recent rally in stocks may provide another fertile environment for these corporate events.

If a private company needs capital that is beyond its own ability to self-finance through operating cash flow, there are a few alternatives the management and the firm’s ownership can utilize to provide that capital. These may include debt, private investment, or public investment through an IPO. Each of these alternatives is evaluated based on current and projected needs for cash.

How does an IPO work?

In an IPO a company’s owners sell a portion of the firm to public investors. This is usually done through an underwriting process that looks and acts a bit like a pyramid.

The company negotiates a sale of its stock to one or more investment banks that act as underwriters for the offering. Each underwriter sells its stock to a much larger pool of investors in the public markets. Underwriters are compensated through fees and underpricing in the stock they are purchasing from the firm. Underwriters take the risk by assuming that they will be able to sell the stock they bought from the firm (that was underpriced) for more than they had paid. An underwriter provides value to the firm by making a large purchase and facilitating an orderly sale of their initial stock.

Moreover, underwriters are running an IPO advertising campaign to raise the stock’s attractiveness and price ahead of the upcoming sale. Accordingly, the larger and the more famous an underwriter is, the more successful the first days after the IPO will be. The largest investment banks such as J.P. Morgan and Goldman Sachs are the most successful underwriters nowadays.

Who Can Buy IPOs?

Traditionally IPOs have been more accessible to institutional entities (e.g., hedge funds, mutual funds, insurance companies) and high-net-worth clients with more capital to trade.

While company executives (and sometimes employees) also have access to IPO shares, investment bank underwriters typically give larger amounts of shares to institutional clients because they believe that they are better equipped to purchase the shares and assume any risk over the long term.

IPOs can be also intriguing for retail investors for several reasons. For one, they allow investors to get in on their favorite companies at the lowest price and capitalize on first-day price surges. Once the shares are available to the public, they can also be financially rewarding to those who participated in the IPO and bought in at its offer price.

That is why several online brokerages have created ways for retail investors to get in on the action. If you don't want to wait until a company's IPO shares have been listed on the exchange, you may be able to get in at the offering price.

However, IPOs also carry notable risks and may not be ideal for beginner investors with long-term horizons.

Risks of buying an IPO

Sometimes IPO can lead to a huge loss as underwrites and other insiders, who have been holding shares since the inception of the company, sell their stocks. Selling pressure can push prices back down and increase volatility.

There is some statistical evidence to suggest that investing in new IPOs can outperform a generic stock index. However, the assumptions behind that evidence indicate that it may not be possible for a retail investor to build a diversified portfolio of recent IPOs. In this case, a great solution might be to find an ETF, which includes recent IPOs.

How to buy an IPO stock?

The SEC lists two ways for retail investors to get in on IPOs. You can participate in an IPO, or, more commonly, purchase the shares when they are sold in the days following the IPO.

To better understand the two ways to buy IPO stock, it helps to know the difference between the offering price and opening price:

Offering price: Though typically set aside for accredited investors and institutional clients with more money to invest, you can also purchase shares of the stock at its offering price if you're a client of the IPO's underwriter. And though it's more difficult to get in as a retail investor, you may still be able to participate in the IPO, depending on your broker.

Opening price: Also known as the go-public price, this price represents the value at which the public can purchase shares on an exchange. You can buy shares through your brokerage after they're resold to the public exchanges, or you can participate in the IPO if your brokerage allows.

Examples of recent successful IPOs

Airbnb. The IPO of the American company Airbnb, an online rental service, took place on December 9, 2020, on the Nasdaq exchange. The company raised $3.5 billion, excluding the purchase of additional shares by the organizers. On the first day after the IPO, Airbnb shares rose 142% to $ 165 per share.

DoorDash. The IPO of DoorDash, the leader in food delivery in the United States, took place on December 9, 2020, on the US stock exchanges NYSE and Nasdaq. The preliminary determination of the placement price, as in the case of Airbnb, was carried out during the auction. As a result of the IPO, the delivery service raised $ 3.4 billion, selling 33 million shares. At the same time, the company's capitalization increased from $25.4 billion to $38 billion.

Examples of recent unsuccessful IPOs

Robinhood. In the first session, Robinhood, the online broker behind the meme revolution of Reddit traders, fell by 8.4% below the IPO price. The starting price of Robinhood's public offering was $38 per share. For IPOs of companies of the same size, this was the weakest opening since the IPO of Uber Technologies Inc (NYSE: UBER) in May 2019 (when Uber ended its debut session with a 7.6% drop).

In addition, such a decline in shares overshadowed another worst debut of this kind of company. In 2007, the IPO of broker MF Global Holding ended with a drop of 8.2% on the first day.

Uber. One of the most recent failed IPOs was the Uber share placement (May 2019). The company has been showing losses for more than a decade, which repels investors. Despite all the efforts of the organizers, the shares fell from $ 45 to $ 27 in six months.

It is hard to dispute that Uber is investing in the most advanced technology of today. Perhaps Uber will still win back its price, as Tesla did in early 2020. However, most investors who buy stocks are only interested in the profit from their growth.

The financial takeaway

You have multiple options for investing in IPO stocks as a retail investor. If you would like to participate in an IPO, make sure to compare the eligibility requirements between different apps and review company prospectuses if possible.

Despite the risks, IPOs will likely continue to attract investors because they are usually issued by companies in a transitional phase. Companies in transitions are exciting and interesting to investors. The prospects for a big win and the possibility of becoming another “IPO-millionaire” can be very enticing.

Nonetheless, it's wise to do thorough research before buying a stake in a newly listed company. IPO investing can be risky even if it's with high-profile companies who've recently crossed over into the public realm. But no matter which investment type you choose, experts recommend investing only what you can afford to lose.

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