See more from Investing

Advertiser Disclosure

What are IPOs and Should You Invest in Them?

Spread the love
Here's exactly what an IPO is and if you should invest in them

I can’t count how many times I’ve thought “If I’d only gotten in on Amazon, Facebook, Tesla, or (insert booming stock here) in the beginning, I’d be a millionaire!”? If you’ve had similar thoughts and want to capitalize on the growth of up-and-coming, new companies, IPOs allow you to do just that.

An IPO is a company’s first time issuing stock to the public and can be amazing growth investing opportunities.

These were once reserved for big investors (like hedge funds and pensions) with deep pockets, but many investing apps have made IPO stocks accessible—and popular—among everyday investors.

If you have a stock trading app like Webull or M1 Finance, you may periodically see notifications of a new IPO that’s available. You may be wondering what exactly IPOs are, whether they’re different from regular stocks, and if they are good investments.

In this article, we’ll cover the basics of IPOs, the process a company goes through to issue stock, an alternative to the traditional IPO process, and whether IPOs are a suitable investment for your portfolio.

Get Your Free Stock Market Guide

What Does IPO Stand For?

IPO stands for initial public offering. This is the process companies go through when they issue new stock.

You may also hear it called “going public,” as companies use this process to go from an entity with a few private shareholders to a public corporation whose stock is traded on national exchanges such as the NYSE or NASDAQ.

How Does a Company Go From Private to Public?

When a company is formed, usually there are just a few owners—often only one or two. As a microcosmic example, when my husband and I started bottling and selling our family farm’s maple syrup, we were the only ones at the helm.

And like all small companies, we were limited by time and money.

We weren’t determined to build a maple syrup empire, but if we had been, we would have looked for people to invest in our company in exchange for a portion of the ownership (these people are called venture capitalists or angel investors).

That would have given us access to more money to buy more bottles, get a bigger boiler, hire more people, etc. so we could make and sell more syrup.

If our company were sufficiently large (a valuation of about $1 billion) and reached a few other metrics, we could (with the legal and marketing help of an investment bank) begin the process of creating stock to issue to corporate and institutional investors like pension funds, mutual funds, hedge funds, etc.

If we completed this lengthy process for our maple syrup company, you could buy shares of Real Good Syrup on the NYSE. (And yes, that was our company’s actual name.)

The extremely simplified run-down of these steps is as follows:

  1. After conducting due diligence, the company wishing to go public selects an investment bank to assist with the IPO process. The investment bank submits necessary documents to the Securities Exchange Commission.
  2. The investment bank creates a book of interest—they use their contacts and marketing to generate and gage the interest of institutional investors to see how many want to buy the IPO stock.
  3. The investment bank and the company set the price of the stock, and the investment bank agrees to buy all of the company’s shares, funding the company’s IPO.
  4. The investment bank sells its IPO shares on the primary market (i.e., the institutions that committed to buy in step 2).
  5. After this, the company’s shares are eligible to be traded on public exchanges, such as the NYSE or NASDAQ.

Once these steps are complete, the institutional shareholders sell their shares to the public, and everyday investors can buy them in their brokerage or retirement accounts.

This whole IPO process can take six months to a year to complete. Nowadays, many companies seek an alternate form of an IPO called a SPAC, which cuts down the timeline on going public.

IPO means a new stock will be traded on the market

Is a SPAC the Same Thing as an IPO?

A SPAC (specialty purpose acquisition company) creates similar results to an IPO (public stock) but it circumvents many of the fees and regulatory oversight of a traditional IPO process.

Recently, SPACs have become a growing trend for companies wanting to go public. Often referred to as “blank-check companies,” these investments have raised $82.1 billion as of 2020.

Here’s the oversimplified version of a SPAC taking a company public:

  1. A group of high-profile investors (or sponsors) create a dummy company with no assets, products, or earnings. Its sole purpose is to acquire another real company that wishes to issue public stock.
  2. The SPAC company is registered with the SEC and offers an IPO, just like a regular company. At this stage, the SPAC usually doesn’t even have a target acquisition in mind.
  3. The money raised through the SPAC’s IPO is stashed in a trust. It can only be used to acquire another company or, if a suitable one isn’t found in two years, to pay back the original investors.
  4. Once the SPAC finds a company to aquire, the two merge. The SPAC’s stock then gets relabeled with the acquired company’s name.

The main advantage of a SPAC is that the acquired company doesn’t have to jump through all the hoops and paperwork required for a traditional IPO. This saves considerable time and money, though this creates a less-than-transparent prospect for investors.

The original SPAC investors don’t know what the company will become in the future, and post-merger investors don’t have the SEC’s regulatory checks that a traditional IPO has.

How Do I Invest in an IPO?

For individual investors like you and me, this can be tricky. Most IPO shares receive commitments to buy from banks, brokers, and investing institutions, so they’re impossible for the average person to access.

Recently, however, online brokers and investing apps like Webull and Robinhood reserve a few IPO shares for interested and financially stable customers.

One recent IPO filing from Figs (a medical scrubs company) notes that 1% of the Class A common stock shares are reserved for Robinhood’s users to buy. I’ve personally gotten several IPO notices in my Webull app during the last two years I’ve had it.

When you place an order for an IPO stock in your investing app, it’s not guaranteed to go through; it merely indicates your interest in it. If the order is filled, it will hit your account on the effective date noted on the IPO notice.

Should I Invest in an IPO?

As with any stock, you’ll want to do your research on any company whose IPO you’re considering. Like all stocks, IPOs can and do lose value, and just because the stock is now public doesn’t mean it’s necessarily a sound investment.

While this isn’t a comprehensive list, you’ll want to know at least these few things before jumping into an IPO:

  • Why is the company selling stock?
  • What will they do with the IPO funds?
  • What is their earnings history?
  • What is the value of all their assets? Their debts?
  • Is the management stable and capable?
  • What’s the company’s competition like? How do they stack up?
  • What is the forecasted growth of the company?
  • How many of the shares is management holding onto?

In short, all of your qualitative and quantitative research should point that the company is poised to grow (in a new market, with a new product, etc.) and is using the IPO to boost that growth.

If the company is using the funds to pay off old debts, look for another investment.

IPOs can be very volatile (meaning they can go wildly up or down) in the first few weeks or months. After all, if the stock is brand new, it’s awfully hard to reliably determine pricing.

This volatility is attractive to some investors and unattractive to others. You’ll have to weigh that volatility against the rest of your portfolio and your own risk tolerance to decide if IPOs are a good investment for you.

I personally haven’t added any IPOs to my portfolio. I prefer more reliable, tortoise-style investments like index ETFs and mutual funds. Passive investing requires much less of my time and energy in research than IPOs would.

True, I may be missing out on the new rockstar companies that will shoot to the moon, but I’d rather rest well at night knowing my capital is growing nicely in proven companies than place bets on the rookies of the market.

How Do I Determine if IPO Investing is for Me?

Because of their volatility and involvement of new, unproven companies, IPOs fall squarely in the risky and speculative investments category. This isn’t where you should put your emergency or retirement savings (or, at least, not much of it).

That said, if you and your portfolio can handle the risk, you can make some fabulous returns. Facebook’s IPO was $32 a share; now it’s literally worth 10 times as much.

Amazon’s IPO was just $16 and is worth $3,244 at the time of this writing—and that’s not counting the three splits it has gone through during that time. If you have the knowledge and time to do the research on IPOs and the patience to hold them, your efforts can be handsomely rewarded.

Our Favorite Investing Tips

Before you delve into complex investing vehicles like IPOs, it’s best to cover a few of the basics of stock investing. Here are our favorite, time-tested investing tips that apply as much to the newbies as they do the seasoned investors.

First, set your investing goals. Before you even look at stocks, you’ll need to take a long look in the mirror and decide what you want out of investing. Ask yourself the following questions:

  • Is this play money you’re trying to grow for fun?
  • Is investing in stocks a way to grow your savings outside of a traditional bank account?
  • Are these retirement funds you want a sure return on for your future?
  • Are you okay with a good amount of risk, or are you prone to make emotional decisions during financial hard times?

The answers to these questions will refine your investing goals, which will be the guiding stars of your financial decisions.

  1. Determine how much you can invest. Personal finance is just that—personal—so we’re not going to put a dollar amount here, or even a percentage. That’s up to you to determine. But the money you invest grows, while the money you spend disappears. So make a budget and consistently put what you can toward your investments.
  2. Choose your investments to align with your goals. If you’re young with a long time for investments to grow, balance risk and reward to make a portfolio that’s aggressive enough to provide the long-term returns you want. If your time horizon is short, choose conservative investments that are unlikely to lose value.
  3. There’s an app for that. Investing apps put all the research, trading power, and flexibility of a traditional broker in your pocket, then eliminates almost all trading fees. Most offer fractional shares, educational content, and specialty investments like REITs, cryptocurrencies, and options as well. (Webull is the one I personally use.)
  4. Stocks offer unique opportunities. Stocks are one of the most varied, common, and lucrative assets available to the everyday investor. They are easy to buy and sell and offer consistently positive returns over the long haul. Most investors have stocks in their portfolio. (Want to know more about how to start investing in stocks? Check out our handy guide for beginners.)

The Bottom Line

IPOs offer the opportunity to jump on a young company’s bandwagon early on so you can (hopefully) enjoy the future periods of meteoric growth.

However, not all IPOs will see such returns, and many do lose value in the short- and long-term. Remember how I mentioned that Facebook gave its IPO investors 10-fold returns?

That didn’t happen until the stock shed almost half its value during the first year.

If you have IPO shares available to you through a strong relationship with a traditional broker or an investing app like Webull or Robinhood, do all the same research you would for a traditional, established stock.

Remember—just because it’s shiny and new doesn’t mean it’s valuable.

Keep Reading:

 

Get the Minority Mindset Stock Market 101 Guide

Written by Jennifer Sisson

Jenni Sisson is a writer and editor who focuses on personal finance, technology, and entrepreneurship. She holds a degree in linguistics from BYU and has spent two years as an in-house editor for KLAS Enterprises, a healthcare research firm.

More From Investing