Fear of missing out on the next big IPO is a big concern.

When the financial news touts a big IPO and the big returns, it’s hard not to want to get in.

For example, just look at these wins:

-Tesla shares have skyrocketed 2,100% since it went public over a decade ago

-Zoom jumped 1,000% higher from April 2019 IPO

-Facebook, on shaky ground these days, has gained more than 600% since its May 2012 IPO debut

-Beyond Meat soared 163% in May 2019… on it’s first day!

But, alas, not all is rosy. Some IPOs will perform poorly.

The financial highway is littered with roadkill from IPO’s who were hit with negative sentiment during a new launch and then never recovered.

In this post, let’s go through what works in an IPO and what doesn’t.

If you’ve been interested in investing in an IPO, then this article is for you and it could be the most important thing that you’ll read today.

Consider it a primer on investing in IPOs.

First, let’s start with the basics.

What Is An IPO

What is an IPO?

IPO is an acronym that stands for initial public offering.

As a private company grows, it first raises money from private investors and venture capital. At some point, the company grows to a point where they need to raise additional capital for expansion. If the company decides to raise additional capital by offering public shares, the private company will go public and issue stock to the public. This process is the initial public offering.

The IPO is underwritten by an investment bank, broker-dealer or a group of investment banks and broker-dealers. These investment banks first purchase the shares from the company, then sell and distribute the shares at the IPO to investors. The company remains a private company until the IPO happens.

To sell the shares, investment bankers use their vast network to find buyers for large chunks of shares. Depending on the company doing the IPO, selling these shares may be easy to do by selling to institutional investors, like other banks, mutual fund owners, and other large institutional investors.

Because the company is trying to raise large amount of money from the public markets, having institutional investors buy large segments of the shares is an easy way to get lots of money by moving large numbers of the shares. And it’s easier to sell a million shares in large lots.

But because the initial public offering sells only a limited number of shares, sometimes the big institutions don’t get as many of the shares as they request. With some IPOs, no single party gets 100 percent of the shares they have requested. In fact, no one gets more than 10 percent of their interest in the IPO share allocation.

IPOs are a way for a company to raise capital to grow their business, pay down debt, or make strategic acquisitions.

What do you need to know before investing in an IPO?

You’ll want to find out everything you can about the new IPO before you invest. In financial circles, this is called doing your own “due diligence.”

Here are some questions to get you started in your due diligence:

Find out how the company plans to use the money raised in the IPO.

How much of the money will fund capital expenditures?

How much of the money will be to expand by hiring more workers?

Will the money be used to pay for acquisitions?

Find out the financial position by analyzing the company’s financial condition.

Does the company current make money?

How is the company currently capitalized?

How much debt does the company have?

What are the upcoming sales projections?

Do you believe the offer price is inflated?

What does the current industry look like?

What are the future growth plans of the company?

Do Your Homework Before You Invest in IPOs

When you first buy an IPO after it hits the market, do your homework first.

You likely won’t be able to purchase the stock at the offering price, so you’ll have to buy your shares when the market opens and they begin trading. The underwriters of the IPO offer shares at the purchase offering price to the larger institutional buyers like mutual funds and insurance. So a private investor won’t have an opportunity to buy shares of the IPO until they are available on the public markets. At that point, you will be subject to the regular buying and selling that determines price.

Because of this, you run the risk to buying at an inflated stock price if the price skyrockets when it hits the public markets and starts trading. This behavior happens if the stock is over-hyped or has gained media attention. IPOs that are highly anticipated attract lots of interest from private investors and this interest pushes up the price, even though the underlying fundamentals and economics don’t support the higher price.

Spark, Pop, or Fizzle

If you watch an IPO on the first day and you see the share price jump up quickly, this is called a “pop.” First day gains like this could mean that the underwriters underestimated the demand for the company’s shares. On the other hand, this is a short-term feature and it does not mean the long-term prospects of the company are better than similar competitors over the long run.

Buying IPO shares on the first day might even mean that investors pay inflated prices, due to the increase of media coverage and public interest. If you look at historical trends, you’ll see that the share price of a new IPO often drops after the large first-day gain. This is due to the frenzy winding down and other factors like performance being used to make valuation of the stock.

Subhead – Stay In Reality

If you’re interested in IPOs and invested in the stock, then you must understand the risks. New IPO shares have high volatility in the first few weeks and sometimes months after a new IPO is launched.

For an IPO, you may consider waiting until you have more business information about the company. Since new public companies have a short track record, it will be harder to get a proper understanding of the business. After the company has gone public, investors will have more disclosed information available for their research. Careful due diligence is critical for all of your investments, and this holds true for IPOs as well.

Final Words

There are many IPOs launched each year, so if you do your own due diligence about the companies and you might be able to uncover the next big IPO winner.

Some investors consider IPOs too risky to get an accurate assessment. Others consider IPOs a viable investment vehicle in which they want to make oversized returns.

If you are considering an IPO, make sure you consider both the upside and the risks involved in the investment.