Should I Invest in IPOs?
💸An Initial Public Offering – also known as IPO, is the first sale of stock (shares) in a company to the public. But is this something you should invest in, and how do you know if an IPO is worth your money?
On today’s Hotline episode I’ll outline what exactly IPOs are, the technicalities involved and whether you should leap into investing in one (or perhaps sit it out).
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1. Why do companies IPO?
To understand why a company IPOs, we first need to take a step-back and understand its funding life cycle.
When someone starts a company, they inevitably will need funding — usually from savings or family/friends — to develop a so called a minimum viable product (MVP). The founder(s) will then sell the idea to private investors (like angel investors) or VCs (Venture Capitalists).
The company can go through several rounds of funding commonly called seed, Series A, B, C. At this stage the company is focused on growth rather than profits hence the need to keep raising money from private investors.
As the company matures and hopefully starts to generate healthy profits, early investors and backers will look for an exit, that could be offering the company’s shares to the public via an IPO or a trade sale for example.
2. How do we open the company’s capital to the public?
With an IPO, the company is looking to sell its shares to the public. The company will go to banks that will use their client base – also called the ‘Street’ - to gauge the interest in the company.
They will also call pension funds, investment managers, large family offices, stock brokers and ask them 1) if they are interested in the business of the company 2) if so at what price and for how much.
Companies will then circle back the information to the company and advise them at which price or valuation they should go public. Once finalised all the details will be published in a prospectus available to all potential investors.
3. the forces at play and technicalities
Most companies are not profitable when they IPO and use that opportunity to raise outside capital. Since the 1980s, unprofitable IPOs have risen from around 20% to 80% of the total IPOs each year.
This is significant because the companies are usually valued on forward growth / business plans. In addition, it is in the interest of the company to make this growth as attractive as possible since it will yield a higher valuation, which will decrease the cost of raising new capital.
When we make forecasts, we are at the mercy of any unexpected changes which might impact the forecasts made. We have recently witnessed several unexpected events like the pandemic, high inflation, and the Russia/Ukraine war, which has put unprofitable stocks under considerable pressure.
When you buy an IPO, you are buying a lot of “Ifs” and if the company is not profitable, it might be difficult to deliver on these forecasts.
According to Investopedia: “A greenshoe option is an over-allotment option. In the context of an initial public offering (IPO), it is a provision in an underwriting agreement that grants the underwriter the right to sell investors more shares than initially planned by the issuer if the demand for a security issue proves higher than expected. […] Greenshoe options typically allow underwriters to sell up to 15% more shares than the original amount set by the issuer for up to 30 days after the IPO if demand conditions warrant such action”
Investors and insiders may only sell a fraction of the capital to the public and use the remainder to raise more capital down the road or enter new markets. This is a partial IPO.
Shares will typically settle or appear on your account 3 days after the deal is closed. After the company goes public, insiders have typically a lock up period during which they cannot sell shares. It is typically between 90 – 180 days.
4. what happens next?
During initial funding rounds when the company is private, it is sometimes possible for investors to exit/sell their investments. For instance, an investor who put some money during the series A funding could exit during the series B, should another investor be willing to buy his shares.
It is nonetheless rare, and the liquidity is poor since there is a limited amount of buyers. As the company goes public, the numbers of potential buyers increase meaningfully, but it also allows early investors to sell pretty much when they want instead of waiting for the next funding round.
Shareholders of a public company can trade larger size and more frequently that a private company. That is an important concept to understand since it may put a “cap” on the company’s valuation as investors sell when the price goes up. Early investors may use IPOs to divest out of their investments.
As the banks look for new investors, they will build a list of potential investors with amounts they wish to invest. This is called the ‘book’. In an ideal world the sum of the interests in the book is higher than the valuation. That will reflect strong demand for the stock. You might have guessed that it creates another potential risk for new investors: you might not get your full allocation if the deal is oversubscribed. While this might not be a big deal for retail investors, it has real implications for index and ETF trackers.
Ipeople didn’t get as much as they want/need, they might buy more as the company’s share become publicly tradable while if they got more than they wanted they might have to sell. This is a bit of a lose-lose since you either don’t have enough while the price increases or you have too much of something while the price drops.
5. so - should i get involved?
To summarize:
Question the valuation at which you are being sold new shares. Try to read as much as you can about the company from experts. Do you already use its product? How much do you know about the company?
Be prepared for volatility, and invest accordingly. Start small and grow your position.
While it can be sometimes be heavy in financial jargons, take the time to read the prospectus detailed the terms of the underwriting. This will help you understand what the future may hold. It may also inform you on green shoe, lock up periods, partial IPO, etc..
Be sceptical of a financial adviser or stockbrokers trying hard to push a particular IPO. Remember: they get paid a fee while you will have the stock performance.
Always weigh up the pros and the cons.
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