What is an IPO?

Fri Jan 15, 2021, 11:54 am | by Charles Munyi | No comments

Chances are that you’re reading this article on an electronic device and accessing it through the wonders of the Internet. That technology is one of the most exciting developments in tech — it’s difficult to think of a time when the Internet and the companies that today offer a myriad of online products and services were not a part of our lives.

However, in the mid to late 1990s, the excitement surrounding the so-called ‘dot-com’ companies was at a fever pitch — and this was reflected in stock markets across the globe. The NASDAQ for instance surged 400% between 1995 and March 2000. It seemed that everyone with an internet-focused idea was listing their company. Some of the companies had business plans and projections that were based on wishful and muddied thinking, while others attempted to translate bricks and mortar operations into dot-com operations overnight. 

What has this got to do with the IPO (Initial Public Offering) of today? The bursting of the dot-com bubble led directly to a tightening of the rules for listing a company on the stock exchange (including the requirement for more detailed and audited information from the company). However, IPO’s still happen regularly. 

Let’s delve a little deeper into the why, the how, and the when of IPO’s in the 21st century — and whether they still offer investors the opportunity to enjoy real returns on their investment.

What is an IPO?

An IPO is a huge day of a business — it’s when it first sells shares of its stock to the public. In essence, there’s a changeover from private ownership to public ownership, hence the process may be referred to as “going public.” With an IPO, privately-owned companies make it to the league of their public counterparts and onto the major stock exchanges like the NYSE and NASDAQ.

Why Companies Go Public

An IPO is essentially a method to raise funds. Companies need to expand in order to flourish in a highly competitive environment. They must fund new operations, research and development, as well as invest in infrastructure. The company also needs to repay early investors for the inputs that allowed it to be established — and reward its founders. 

In order to grow and remain competitive, a company needs capital and an IPO (or ‘going public’) can provide that capital. It may also offer the opportunity for the shares in the company to be valued at a significantly higher level than would otherwise be the case (due to the interest of institutional investors and the public) and therefore enjoy an injection of capital that may not have been available through other funding mechanisms.

The process of taking a company public is an elaborate dance where certain established partners take to the dancefloor. The first are the investment banks who will be offered shares in the company, often at a discounted rate in order to ensure interest and secure large tranches of investment. 

The company will first select an underwriter who will pitch for their business and offer advice on the best type of security to offer, the number of shares that should be offered, and the timing of the offering. Once the underwriter has been selected, an IPO team is established consisting of legal representatives, financial experts (usually CPAs), and experts in the rules and regulations governing the stock market (Securities and Exchange Commission (SEC) experts).

In the United States, an S-1 Registration Statement is compiled. This consists of a prospectus and privately held filing information. Marketing material is developed which will be used to pitch the company to potential investors (most often including the public and large asset managers) and the pitching process begins. Then the company is required to ensure that all necessary steps have been taken to comply with exchange listing requirements and SEC requirements. The Board of Directors is formed and reporting processes are set in place. 

Then it’s time for that final dance of the IPO evening – the issuing of the shares.

How to Invest in IPOs

There’s no doubt that investing in an IPO is an exciting prospect. The risk/reward ratio can work in one’s favor — and that lure of seeing an initial investment provides exceptional returns is a siren call, who among us hasn’t dreamed of snatching up Apple, Microsoft, or Amazon shares when they first listed?

First, carefully evaluate the offering (reading that all-important S-1, including the prospectus). Pay special attention to the company’s total addressable market (TAM). These companies have not (usually) been around long and are sometimes market disruptors. The information on the TAM will give insight into the growth potential of the company and how much consumers are already spending on products or services.

Go to the company website and look for the contact details for the organization’s investor relations representative. Ask if the shares are available through an initial private offering. If this is the case the representative will most often direct you to the company’s broker/dealer and you will be asked to transfer funds in order to complete the sale.

If you have a stockbroker they may be able to handle the transaction for you using the funds in your brokerage account.

Once this initial process is complete you will be issued with share certificates. Today ‘virtual certificates’ are rapidly becoming the norm. 

Is Investing in IPOs a Good Idea?

IPOs may still offer you a significant opportunity to bolster your stock portfolio and enjoy a superior return on investment. However, the Latin saying — ‘caveat emptor’, ‘let the buyer beware’ should always be kept in mind. The fundamentals of the company that’s going public and its business plan and projections, as well as the competitive environment within which it operates, should be carefully scrutinized.

It’s always important to remember that the marketing campaign of the company can sometimes cloud investment judgment — as can market hype. Many companies that are seeking an IPO do not have a long trading history — and therefore basing the investment decision on a financial track record can be problematic. However, a company going public is required to furnish balance sheets, income statements, and cash flow statements. Evaluate these carefully — and when in doubt consult a qualified investment advisor or your CPA.

Always remember to temper your expectations. Investing in IPOs carries an element of risk. Balance your appetite for that risk, your financial situation, and the potential rewards. 

How to Find Out About IPOs

If you want to keep an eye out for promising IPOs there are numerous portals that can be of help. The websites for exchanges like NASDAQ and NYSE contain information on upcoming IPO’s — and these can alert you to the fact that the IPO wheels have been set in motion. 

However, subscribing to live market news feeds such as Benzinga Pro (set up IPO alerts as a search criteria or open up the IPO calendar) can provide you with timely information, valuable insight.

Click here to start your free, two-week trial of Benzinga Pro.

It’s worth repeating that the key to successful investing lies in research and review of the available documentation, especially the S-1 documentation.

Final Thoughts

Markets are subject to pressures that are incredibly complex to understand. Hype can sometimes blind us to reality and the pure of riches can be almost impossible to resist. However, marketing hype is often just that — hype. Remember the old adage ‘today’s news is tomorrow’s birdcage lining’. 

Marketing companies – and even those who develop a prospectus, are selling – they might position a company as ‘the next big thing’ — however the market, the competitive environment and the fickle nature of the consumer will all contribute to the success or failure of an IPO. IPO’s represent enormous opportunity — but with that opportunity comes risk. Make sure to do your due diligence before making any investment decision.

Disclaimer: Benzinga is a news organization and does not provide financial advice and does not issue stock recommendations or offers to buy stock or sell any security. Benzinga Pro is for informational purposes and should not be viewed as recommendations. Benzinga Pro will never tell you whether to buy or sell a stock. It will only inform your trading decisions. You can find our full disclaimer located here.