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IPOs are exciting for investors because they're often the first chance to own shares of a young, innovative company. But navigating IPOs is not always as simple as it looks.
This is a process involving many accountants and lawyers. It's loaded with red tape.
On top of that, private institutional investors have better access to the stock at its IPO price, long before retail investors get a chance to buy.
These big investors have a better understanding of the company as a result.
So, if the big and smart money get first dibs on an IPO, why should retail investors care about IPOs in the first place?
Believe it or not, knowing a few things about the IPO process can put some individual traders leagues ahead of their peers. It can even put them near par with some of the institutional investors in the market for the same stock.
If you want to know when is best to invest in a new stock, we cover that here. We'll go through a few of the different ways companies choose to go public and how that can affect your investment. That will cover the different moving parts of an IPO, the difference between an IPO and direct listing, and much more.
Finally, we'll show you some of the most exciting upcoming IPOs on the horizon.
If you've ever been interested in IPO investing, this is your definitive IPO guide.
Let's get started...
What Is an IPO?
An initial public offering (IPO) is the first time a private company offers shares for purchase on the public market.
Before going public, a company only raises capital from private investors - usually accredited investors, banks, or venture capital firms. It's possible to invest in private startups, but you can't buy their stock on a public exchange. (You can learn how to invest in startups before they even go public here.)
An IPO opens the company to thousands of new investors, either on the New York Stock Exchange (NYSE) or another exchange. This creates an opportunity for the company to raise funds from the public market, in addition to what they have raised from private investors.
There are many legal hoops to jump through in the IPO process, which is why it can take around four to six months between filing with the U.S. Securities and Exchange Commission (SEC) and actually selling those shares to the public.
Major financial institutions are typically involved in underwriting an IPO to ensure the process is smooth, accurate, and profitable for the company. Underwriters are paid to take on some of the risk in going public. They buy shares from the company, gauge interest with financial institutions like banks and insurance agencies, and then sell the first shares in the public market.
It's in the underwriter's interest for there to be demand for shares. If shares are too expensive, investors won't buy. If they are too cheap, there may not be enough shares to meet demand. The speculation could bubble and crash the stock. That's why the underwriter wants just the right price and number of shares to go public.
There are many reasons a company would want to be publicly traded, and many reasons it would not want to go public. It all depends on the company and where it stands at a particular moment in time.
There are also various flavors of public offerings that could suit different companies under different circumstances.
We will get into which companies would pursue which types of IPOs in a minute. First, a little about how IPOs work...
How the IPO Process Works
An IPO starts with an "issuer" and a "syndicate."
The "issuer" is the company desiring to issue new shares of stock to the public. The "syndicate" is a group of underwriters, usually one or more investment banks. The lead bank in the syndicate is called the "bookrunner."
These partner together for mutual interest. An issuer wants to bring in as much revenue as possible from an IPO. Underwriters want the same, because they get a cut of that revenue for helping the shares go public.
More specifically, underwriters are paid by the issuer to sell the initial shares to the public, as well as broker legal agreements with the SEC. The fee for selling the shares is called the "underwriting spread," which is simply a percentage of the shares sold to the public.
How an IPO Is Priced
IPO prices depend on the type of contract the company has with its underwriters.
A best-efforts contract is when the underwriter agrees to sell as many shares as possible at an agreed-upon price. The underwriter is not obligated to keep that fixed price if no one buys.
A firm commitment contract is different. This is an agreement by an underwriter to sell shares at a fixed price. It is the safest bet for a company looking to IPO, but it is more expensive. The underwriter is taking on significantly more risk, unable to sell if the price is too high.
This can be disastrous for an IPO. If priced too high, a lack of buyers can sink the price, and it could tank the stock well below fair value as public perception takes hold.
To protect from events like this, issuers sometimes have an "insurance policy" in place. This is called an all-or-none contract.
With all-or-none, the underwriter must sell all shares or the deal is void. Sometimes, the underwriter must buy any shares not sold.
The "bookrunner," or the lead underwriter in the syndicate, is charged by the issuer with helping the stock arrive at the agreed-upon IPO price. The price can be determined and fixed by the issuer. Or the bookrunner can analyze investor demand and offer a reasonable price to the issuer.
Companies will often underprice an IPO to boost interest in a stock. But retail investors don't get access to the stock yet at that point.
Instead, accredited investors and financial institutions in the underwriter's distribution network get first dibs. They will use this as an opportunity to "flip" the stock as IPO excitement pumps the price.
That's why the IPO price set by the underwriters is different than the price it goes for once it's trading on the exchange.
If an IPO is promising, insiders will buy at its IPO price, watch it soar, then sell before it goes down to fair value. By the time retail investors have a crack, the stock price at open could be far higher than the IPO.
It's very hard for retail investors to get the stock at the IPO price. You would have to call your broker to see if you can get shares. If you can, it probably means the big investors don't like the stock, which would mean it's not a buy anyway.
On the other hand, if interest in a stock is too high to begin with, this could cause some problems as well. Underwriters shoot for a low IPO price for this reason.
The 2012 Facebook Inc. (NYSE: FB) IPO was a prime example of shares selling higher than market demand, falling, and struggling to regain ground.
Facebook lost initial investors more than 40% within its first few months of trading. This might not have reflected the fair value of the company. But the initial slip caused the public to lose confidence in the stock. As a result, it became harder to sell.
This is why underwriters are so important to the IPO process. They are always looking for an optimal price. They want it to be high enough that the company will raise capital and low enough that the market will still want it.
Once a price is agreed on, initial shares are sold to institutional investors and clients of the underwriting investment banks.
Sometimes, there is overwhelming demand for shares of a stock. This means the issue is "oversubscribed" or a "hot" issue. In this case, underwriters are often given the option to sell 15% more shares.
This agreement to increase the allotment is called a "greenshoe." It risks diluting the price of shares, so issuers want to be certain a stock is oversubscribed before increasing supply.
If you see an IPO you like and you hear it's oversubscribed, this probably means you're going to have to pay a lot more to buy it on a public market. Otherwise, an undersubscribed company pre-IPO may be a sign not to buy.
The IPO Quiet Period
The SEC requires that every IPO have a mandatory "quiet period." This is a time when the company is kept from promoting the IPO. They can't make any price predictions or projections about the company's value in public.
Of course, shares can't be offered or sold during this time, either.
Investors can, however, give an indication of interest (IOI). It is non-binding, but it can be converted into a buy order when the time comes.
Whether or not you can submit an IOI for a stock depends on if the broker has it or not.
In every IPO registration, the underwriters will work with some brokers and not others. The first thing you want to ask your broker, then, is if they have a piece of the stock in question.
Only accredited investors can submit IOIs for upcoming IPOs. This means you would need an account minimum around $200,000 for your broker to consider giving you an IOI.
Underwriters and brokers want to ensure that anyone requesting an IOI is serious about their interest. Your broker may also ask you some questions to ensure you have done your due diligence.
When an investor states their interest, the broker gives them a preliminary prospectus.
This is what's called a "red herring" prospectus. It's a registration statement including all the information an investor would want to know about the company.
What makes it a "red herring" is that it is incomplete and still not approved by the SEC. It comes with the caveat that the information could be misleading since it's not finalized.
During the quiet period, the issuer's accountants and lawyers have an opportunity to edit and perfect the details before having the prospectus officially approved by the SEC.
The IPO Lockup Period
Another important period to consider is the IPO lockup period. This is typically a 180-day period after an IPO when company insiders can't sell shares. "Insiders" here can mean anything from founders to employees, and even early private investors.
Lockup periods exist to control the share price. They do this by keeping major shareholders from flooding the market with shares.
Because the big-time investors are kept from selling their shares for a while, it also works to preserve retail investor faith in the future of the company. If there were no lockup period, and a big investor decided to sell his entire stake, many retail investors would see it as a bad sign for the company and never buy.
Lockup periods are not SEC regulation, but a contract provision often required by underwriters who want to keep the price up after the IPO.
Michael Robinson, Money Morning's Defense + Tech Specialist, says it is often best to wait until the lockup period ends to buy shares. It gives you an opportunity to see how many insiders unload shares. If there is plenty of selling, it could drive down the price of the stock.
If it's a good IPO, Michael says the best gains could be "in the first two years after that."
Why Do Companies Go Public?
An IPO is an opportunity for a business to raise capital for growth by selling shares to a public market. For example, Snowflake Inc. (NASDAQ: SNOW) raised $3.5 billion in its first eight years of existence. But it raised $4 billion the moment it hit the NYSE, the biggest software IPO of all time.
IPOs can also be a huge payout for insiders at a company. A business will decide to have an IPO if it believes there is enough demand from the public markets to earn strong revenue from the event.
Long before going public, a private company goes through different "rounds" of funding. The private market will have its own expectations of how the startup should grow. Private investors could be interested in a big cash-out from going public, like what Mark Zuckerberg and Jeff Bezos received from Facebook Inc. (NYSE: FB) and Amazon.com Inc. (NASDAQ: AMZN).
That said, going public is by no means the only reason venture capitalists invest in stocks. A VC or angel investor is always looking for growth, but it could be realized by selling on the private market as well.
Early investors can also hope to get acquired by a larger public company if the product or service is promising.
On the flip side of that, a company might seek IPO revenue in desperation after exhausting private investment.
Either way, executives want to be absolutely certain an IPO would profit the company's image and fill its top line before pulling the trigger. If a company believes an IPO will diversify its investor base, gain cheaper access to capital and improve its public image, it will probably go for it.
That is only the most basic reason for an IPO, however. There are plenty other reasons a company would, and other reasons it wouldn't...
Why Do Companies Stay Private?
A company may hold off an IPO or scrap it altogether if it does not see an opportunity in growing capital or improving image. IPOs can be time-consuming and involve a lot of legal hoops, number-crunching, and marketing costs.
A company may also have issues disclosing financial business information, some of which it might not want competitors to see.
Entering the IPO process, a company also has the risk of not hitting its targets. The contract might be a bad fit for the company, either by fault of the underwriter or the issuer. As a result, the price might not be what the issuer wanted. And all the time and energy spent on the IPO would go to waste.
Young companies with limited capital may have trouble keeping up with the SEC's financial reporting requirements and other rules. There's the workload, but also the financial cost of staying compliant: printing documents, paying auditors, etc.
For these reasons, a company might put off an IPO for a few more years of private growth.
Trading on the public market can also be an issue for business leaders used to being solely in control of their company's direction. These kinds of issues have kept many companies from going public over the years.
This is especially true during a pandemic. With higher economic uncertainty and volatility in major indexes, you're less likely to see IPOs take place.
In early 2020, when the pandemic crashed the S&P 500 more than 30%, there was not much IPO news to go around. Investors were more interested in safe-haven investments like bonds and gold, much less a new unicorn startup with a bold, unproven product.
For this reason, we saw several businesses postpone their IPOs, while others took alternative routes to trading on the public markets.
The Airbnb IPO is one that has been continually pushed back due to questionable demand by the market. Investors were excited about buying some of the stock in 2019, then in summer 2020, then in the fall.
The company then decided to push its IPO back even further, to 2021, due to the coronavirus.
Airbnb is not alone in a year of wide ups and downs. One thing companies always fear in preparing for an IPO is the unpredictable nature of the public market. The famed author Benjamin Graham refers to "Mr. Market" as a "manic-depressive," in fact.
Luckily, there are a couple alternatives to traditional IPOs that have been employed this year...
What Is a Direct Listing IPO?
A direct listing, or direct public offering (DPO), means a company is not going to sell new shares. It only gives its shareholders the opportunity to sell existing shares by floating them on the public market.
There are practical reasons for companies to go public through a DPO. The first is to preserve the share price. They don't want to risk shares being diluted if more are created. Another is to save money by not having to pay underwriters or other intermediaries for their services.
Direct listings also don't have lockup periods. Insiders can sell shares from day one.
Palantir went with a direct listing instead of a drawn-out IPO process this year.
Because there is no underwriting process, there is less regulatory scrutiny, and shares go to market quicker. A direct listing on the NYSE only requires the company to have an independent, third-party valuation coming out to at least $250 billion.
Of course, after going public, the stock is subject to the same SEC rules as all others.
Direct listings are an opportunity for early investors to make money from shares in the public market. But this can benefit retail investors as well.
Since there is no middleman, no need to go through various underwriters and brokers, there is less mystery around the price you get when the stock goes public. Often, retail investors won't have a chance to buy at the advertised IPO price. Insiders will have already pumped it up.
This is not the case with DPOs.
A disadvantage of this could be that retail investors are buying the stock directly from insiders who are ready to sell. Insiders will know more about the stock than retail investors, so you have to wonder what's prompting them to sell at that time.
Direct listings aren't the only exciting way companies have been going public either...
What Is a SPAC?
The special purpose acquisition company (SPAC) is also known as a "blank check company."
SPACs raise money from IPOs and use that money to buy promising new startups that might otherwise not choose to go the traditional IPO route.
Pershing Square Tontine Holdings (NYSE: PSTH) is one SPAC that raised $4 billion in an IPO this year. CEO Bill Ackman has said the company plans to invest in real estate unicorns.
There were talks of this SPAC merging with Airbnb, but this fell through. Pershing Square may still have plenty of other options to choose from.
While IPO proceeds decreased by 67% in April-May 2020, there was a new rush toward SPAC investing. With SPACs, companies can get to market without negotiating with underwriters.
The money has already been raised through underwriters. All that needs to happen is a reverse merger between the SPAC and the unicorn company of interest.
With SPACs, the lockup period can go beyond 180 and up to a year. This is because it takes time for the company to find and merge with its target company.
The SPAC absorbs that company and changes its ticker.
This happened with several companies in 2020, specifically in the electric vehicle market.
Nikola Corp. (NASDAQ: NKLA) merged with the SPAC VectoIQ to get its shares public. The Tortoise Acquisition Corp. SPAC merged with electric truck maker Hyliion Holdings Corp. (NYSE: HYLN) to get its shares off the ground. DiamondPeak Holdings Corp. (NASDAQ: DPHC) announced it would merge with Lordstown Motors and eventually trade under the ticker RIDE.
Like IPOs, SPACs carry their own risks for investors. You don't know exactly what you will be investing in. But you try to get an idea by looking at the company's decision makers and seeing if you trust their judgement.
In the case of Pershing Square, the company is led by Bill Ackman, a billionaire that turned $27 million to $2.6 billion in the coronavirus crash. For some investors, this could be enough to know their money will be put to good use.
SPACs had a blowout year. According to SPACInsider.com, more than $22 billion was raised through SPAC offerings in 2020.
We've covered how IPOs work, and a few different variations. Now, let's get to the main question at hand.
Should You Invest in IPOs?
There's no rule of investing that says IPOs are either good or bad. It's important to judge each opportunity on a case-by-case basis.
Some are amazing opportunities to get in as early as possible on an incredible company like Alibaba Group Inc. (BABA) - a $25 billion IPO on a company now at a $831 billion market cap.
Others are clearly a cash-out for founders that could cost you money. Lyft Inc. (NASDAQ: LYFT), for example, has lost nearly 70% of its price since its IPO. And in hindsight, it makes sense. The company has not been profitable, only to throw away its revenue in a price war with the slightly more successful Uber Technologies Inc. (NASDAQ: UBER).
Your main concern with IPO investing should always be to separate the hype from the facts. IPOs tend to excite investors, but not every IPO is worthy of interest.
Money Morning VC Advisor David Weisburd says you can discern this by first making sure you're "investing in a business and not a product."
In the case of Lyft, investors were probably more interested in the ride-hailing product than the company itself. Look past the flashy idea that the company is promoting and see if it has proven it can make money.
The company doesn't necessarily have to be profitable yet. But it's helpful if it has a path to profitability.
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Many companies go public while still in their growth stages. That means they will still be spending money to build their business. Look at the last few years of the company's revenue to see if it's been growing. If you can find information about its debt, whether or not it's manageable, that is a plus.
The point here is to stay as informed as possible. In light of that, a company with a management that provides any additional guidance might also be worth investing in.
Another way to see if you can trust the management is by finding out if they have invested in the company themselves. You can tell by seeing whether they are paid in stock or cash only. You want these people to have a real stake in their company's success.
Learn as much about the leadership as you can. Dive into their history and see if they have a good track record with other companies. If you don't see much success there, or the company has a lot of top-level turnover, you might want to stay away.
Lastly, you want to make sure you're getting a fair price. Even if everything with the company checks out, it might still be a bad deal if you have to overpay. You want to make sure you're paying the right price for your investment, just like with any other stock.
Money Morning Chief Investment Strategist Shah Gilani says to pay attention to the expected valuation. If the stock opens at the very top of its valuation range, or above it, then it might be a good idea to hold back and wait for shares to settle down before buying.
Same thing if the stock opens near or below its expected valuation. Negative sentiment could push it down ever further, giving you a chance to buy low.
It is also not a bad idea to give the stock some time to settle before buying in either way. IPOs are notoriously volatile, so giving the stock a few weeks, or even a quarter, to shake out will give you a much clearer picture of how the market views the stock.
Now, here are some of the best IPOs that could be on the horizon over the next few months...
The Best IPOs Coming Soon
Rivian is an electric vehicle manufacturer that has been called the "Tesla Killer." There is no Rivian IPO announced yet, but once it goes public, it will be a most-wanted EV stock.
Airbnb has struggled through the COVID-19 crisis, but the home rental company has slimmed down its expenses and raised its valuation significantly ahead of its expected IPO in 2021.
The Roblox IPO is one of the most exciting upcoming IPOs. It's a video game platform with an enthusiastic user base.
DoorDash is a third-party food delivery service in competition with Grubhub and UberEats. It controlled 45% of the food delivery app market in June.
Flipkart is an e-commerce company owned by Walmart Inc. (NYSE: WMT). With online buying accelerating during COVID-19, stock traders are excited to own shares of this one coming soon.
Freshworks is a software company with a fast-rising valuation leading to its 2021 IPO. COVID-19 set the date back, but it has given time for the company to strengthen its balance sheet.
Qualtrics is a cloud computing company that uses artificial intelligence to gather customer, employee, brand, and product insights into one platform for executives.
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