What Is an IPO?

You might have heard about a new IPO Alibaba that is about to be brought to market.  This is the Chineese equivalent of Google and American investors are going “gaga” over the prospects of buying shares.  The shares might do really well of course but nobody really knows.   As  a result, I thought I’d republish this post on IPO’s so you can understand what the process looks like and then determine if you want to participate or not. This first appeared in February 2012.

I’m sure you’ve heard the term “IPO” before, but do you know what it is? Most people don’t – even those who buy them. So what is an IPO, and are they good investments?

The Definition

IPO stands for Initial Public Offering. In other words, it is a new issue of stock offered for sale to the public. When companies first start out, the shares are held privately. At some point, a majority of the owners decide they want to sell off a portion of the company to the public in return for cash.

Why do companies offer IPOs?

There are a few reasons. First, the owners might just want to cash out all or some of their investments in their own company. In other words, they do it to balance out their own assets. Even if you were Bill Gates, would you want all your net worth tied up in Microsoft stock? Bill didn’t, and you probably shouldn’t either. For some business owners, it’s simply a way to diversify their risks.

But more often than not, companies do an IPO because they want cash to expand operations. They see an opportunity to grow the business and take advantage of economies of scale, but they need cash to do it. By selling a portion of the company, they can get their hands on that cash.

Of course the company could borrow (sell bonds) rather than raise equity (sell shares), but that would create a liability. They would have an obligation to pay interest on that debt. If the company is cash-poor, it may not be able to make those interest payments. Also, if a company is very young, it may be difficult to get a loan. That’s why the IPO may be their only choice.

Finally, some companies are on the edge of going under, and they need the cash just to stay afloat. They offer the IPO to create working capital so the company can keep going. These are often the riskiest IPOs, but they sometimes offer the potential for a big payday.

Regardless of why the company is going forward with the IPO, when it does so it will sell a portion of its shares, and the original owners will retain some portion of the remaining shares in most cases.

What are the downsides to a company of issuing an IPO?

It costs a great deal of money to pay for the SEC filings, the attorneys, the bankers and everyone else. And after the company issues the IPO, it’s considered a public company. That means it must adhere to a number of regulations, audits and filings that weren’t required while the company was private. These are also expensive propositions, and it is a drag on the company’s profits. Not only that, when other people buy the shares of the company, that means they become owners.  And that means the original owners may lose some control.

The new owners will put pressure on the company to deliver short-term performance. They want dividends, and they want short-term profits to drive the price of the shares up. Those goals might be shortsighted and may even hurt the company in the long term. While the company was privately held, the owners didn’t have those pressures and could focus on long-term growth instead.

Is an IPO a good investment?

If you ask the people who bought Google, Apple, and Microsoft at the IPO and who still own those shares, they’d say yes. But there are plenty of IPO purchasers who have very different opinions.  IPOs can involve tremendous investment volatility.

According to the Motley fool, of the 116 companies that issued an IPO on the Nasdaq in 2011, only 25 were trading above their initial offer price. The average loss at the end of trading after only a few days of going public was a loss of 20%. Ouch.  And University of Florida has an even gloomier report.  They looked at all the IPOs between 1970 and 2011 and found that the average IPO underperformed similar firms by 3% on average during the first 5 years after going public.  And in years 1 and 2, the average IPO lagged it’s peers by 18% and 6.3%  respectively.

How are IPOs priced?

When a company decides it wants to bring an IPO to market (“go public”) it uses a group of brokerage firms to “underwrite” the issue. To make a very long story short, they do a lot of the legal work and try to assess the value of the company by comparing its ability to make a profit (in the short and long term) to other similar companies.

Also, the firms look at how comparable companies are valued in the market. Using all this information, they determine a value of the company and the shares. But this valuation changes by the day, and the initial offer price can fluctuate wildly up to the day the shares are offered. You never really know what the final offer price is going to be until a short time before the shares are made public.

So, for example, the shares might be sold at the IPO at $45 per share based on what the underwriters and existing shareholders agree on. The people who participate in the IPO will then get the shares at this price. The moment all the participants get the initial shares, a secondary market is created. That’s when the shares are traded on the open market.

If we examine the LinkedIn IPO in 2011 we see that the IPO price was $45, but the moment the shares were traded on the open market, the price shot up to $84. Why? Because the underwriters didn’t really price the shares exactly where they should have. The people who got those shares on the IPO (at $45) did really nicely. The current price is $149 as of 5-20-14.  Even people who got shares on the secondary did nicely.

At the same time, keep in mind that most people who participate in IPOs aren’t so lucky. Again, out of 115 IPOs traded on Nasdaq in 2011, only 25 are traded at prices higher than the IPO price as of the end of the year.

How can you participate?

In order to participate in an IPO you must have a brokerage account with one of the firms participating in the offering – usually one of the firms that did the underwriting. If you do have an account, all you have to do is call the broker and put in your order. On very hot issues, you may get only a portion of the shares you want, or you may not get any at all. The broker won’t tell you this, but typically the shares of the best IPOs go to the largest brokerage clients. Life isn’t fair.

Should you participate?

The IPO market is highly speculative. You could do really well, or you could get your head handed to you. If you really love a company and have a basis for thinking it will perform well, you can try to get shares on the IPO, but you can also just buy them on the secondary market if you aren’t awarded the shares. But before you take the plunge, study the investment and read the shareholder letters and financial reports. This will help you learn about the risks you are taking.

If you want to increase the odds of making a good decision, read the offering documents. Is the company profitable? What is the business model? What is the competition? Are there any lawsuits pending?

Many times unprofitable companies come public and do really well on the IPO, but they tank sooner or later. That’s because the long-term value of a company is a function of how profitable it is. A company cannot continue to lose money and do well in the market.

Most people who are interested in an IPO speculate that the market will explode and they will make a killing. I’m trying to point out here that this is not always the case and you’re be far better off if you simply do some homework and make sure the company is profitable. If so, try for the IPO. If you don’t get the shares, buy them on the secondary market.

Have you participated in an IPO? What was your experience?