IPO is an acronym for Initial Public Offering. This is the first sale of stock by a company to the public. Getting a piece of a hot IPO is very difficult, if not impossible. To understand why, it helps to know how an IPO is done, a process known as underwriting. When a company wants to go public, the first thing it does is hire an investment bank. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters as middlemen between companies and the investing public.
The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued, and all the details in the underwriting agreement. The deal can be structured in a variety of ways.
Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the SEC. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used, and insider holdings. The SEC then requires a “cooling off period,” in which they investigate and make sure all material information has been disclosed. Once the SEC approves the offering, a date (the effective date) is set when the stock will be offered to the public.
During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren’t known at that time. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue. They go on a road show where the big institutional investors are courted.
As the effective date approaches, the underwriter and company sit down and decide on the price. This isn’t an easy decision: it depends on the company, the success of the road show, and most importantly, current market conditions. Of course, it’s in both parties’ interest to get as much as possible.
Finally, the securities are sold on the stock market and the money is collected from investors.
As you can see, the road to an IPO is a long and complicated one. You may have noticed that individual investors aren’t involved until the very end. This is because small investors aren’t the target market. They don’t have the cash and therefore hold little interest for the underwriters.
If underwriters think an IPO will be successful, they’ll usually pad the pockets of their favorite institutional client with shares at the IPO price. The only way for you to get shares (known as an IPO allocation) is to have an account with one of the investment banks that is part of the underwriting syndicate. But don’t expect to open an account with $1000 and be showered with an allocation. You need to be a frequently trading client with a large account to get in on a hot IPO.
Bottom line, your chances of getting early shares in an IPO are slim to none unless you’re on the inside. If you do get shares, it’s probably because nobody else wants them. Granted, there are exceptions to every rule and it would be incorrect to say that it’s impossible. Just keep in mind that the probability isn’t high if you are a small investor.
The good news is that investing in an IPO is often a bad idea. An IPO company is even trickier to analyze than a regular company since there isn’t a lot of historical information. And, many IPOs that have big gains on the first day will come back to earth quickly as the institutions take their profits.
Also, if you look at the charts following many IPOs, you’ll notice that after a few months the stock takes a steep downturn. This is often because of the lockup period. Lockup agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The problem is, when lockups expire all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.
Remember, the whole process is intentionally hyped up to get as much attention as possible. But, many IPO’s end up selling below their offering prices within the year. Don’t buy a stock only because it’s an IPO – do it because it’s a good investment.