All About IPOs

January 13, 2015  | By Kevin Smith

Maybe you’ve heard someone talking about investing in “a hot new IPO” and wondered what all the fuss was about. Or maybe you’ve heard about a company “going public” and thought about whether you should invest in it. If you’re unfamiliar with initial public offerings (IPOs), here’s a review of some basics.

What is an IPO?

As the name implies, an initial public offering represents the first time a company issues shares of stock that are available for purchase by the public (in other words, when it “goes public”). The sale of the company’s stock is typically intended to attract new capital that the company can use to expand. IPOs might be considered the rock stars of the investing world; when the company has generated a lot of interest leading up to its IPO, the initial response from investors can make headlines.

How does an IPO work?

Once the decision is made to go public, a company hires an investment bank to coordinate underwriting issuance of the IPO shares. The underwriter (or team of underwriters) guarantees it will purchase all of the company’s shares on the day the stock is issued. However, underwriters typically do not intend to keep all of those shares, so they market them to other firms and financial institutions in advance of the actual IPO date. Firms that want to subscribe to the IPO indicate their interest in buying a certain number of shares (though they’re not bound to follow through on that purchase). This process gives the underwriting firm(s) an idea of how much interest the IPO will generate. If there’s a lot of interest and a large number of subscribers, the offering price can rise before the IPO date; if interest is low, the offering price will likely reflect that as well.

However, the offering price may be very different from the price at which the stock trades on its first day. That’s because once the subscribing firms have begun trading shares they’ve bought, the price can change dramatically, depending on the overall level of market interest. At that point, as with any stock, shares are sold to the highest bidder. The more limited the supply of shares available, the higher those bids are likely to be. That’s why you may sometimes read headlines about the price of an IPO jumping on its first day.

What happens after the IPO?

Even if an IPO is eagerly awaited, there’s no way to know exactly what will happen once the stock starts trading. Yes, an IPO’s price can skyrocket, but it can also go nowhere or disappoint–or skyrocket and then disappoint. Facebook’s May 18, 2012, IPO was one of the most highly anticipated IPOs in recent years. And yet on its first day of trading, after an initial pop it closed up only 23 cents–roughly .006%–from its offer price; at the close of trading three weeks later, it was down roughly 30% from its offer price (though it subsequently rebounded and as of October 2014 had roughly doubled from the first-day close).*

What’s behind such volatility? One reason is that after any initial jump in price, the institutional firms that have subscribed to the IPO may want to take any profits quickly. Also, executives at companies that go public often have signed what’s called a “lock-up” agreement; for a certain time after the IPO, they’re prohibited from selling shares that may have been granted as part of their compensation package. Such agreements are designed to help support the stock’s price during the lock-up period, which lasts at least 90 days but can be longer. However, once the lock-up expires, executives are free to trade their stock. If many of them sell simultaneously, the sudden increase in the supply of shares on the market may cause the stock’s price to fall.

What if I want to invest in an IPO?

One challenge with trying to invest in an IPO is simply gaining access to the shares. In the case of a stock that’s in high demand, firms typically reserve IPO shares for their largest or most valued clients. For example, a firm might offer its IPO shares only to investors who have a certain level of assets with the firm or a minimum trading volume. If you’re a small investor and are being offered IPO shares, it could be because the demand for them is less than expected, which could have implications for your investment in them.

Even though past performance is no guarantee of future results, an IPO can be especially difficult to analyze for its long-term potential because it doesn’t even have a track record to review. One tool is what’s known as a “red herring.” This is an initial prospectus that contains pertinent information about the company; it’s issued after the Securities and Exchange Commission declares the registration statement effective. However, be aware that though the red herring is subject to SEC reporting regulations, it’s part of a sales campaign by the underwriters to try to drum up interest in the IPO. Don’t be tempted to invest in an IPO just because it’s an IPO; think about whether it fits into your overall investment strategy and tolerance for risk.