What Is an IPO?

Investing in an initial public offering (IPO) can deliver attractive returns. However, you should research the company and process, thoroughly understand how trading these securities differs from typical stock trading, and be aware of the additional rules and risks before deciding whether to invest in an IPO. 

What Is an IPO?

An IPO is when a private company first sells stock shares to the public. Because the company’s ownership transitions from private to public, the process is called “going public.”

Startups and established companies might decide to go public. Common reasons for an IPO include the following:

• Pay off debts.

• Fund growth initiatives.

• Raise the company’s public profile.

• Let company insiders diversify their holdings.

• Allow insiders to sell some or all of their private shares as part of the IPO to create liquidity.

Conduct Thorough Research Before Investing in an IPO

Avoid getting swept up in the hype surrounding a startup’s potential. Many companies that debut with high expectations struggle and close down within a few years.

For instance, investors in IPOs during the tech stock boom and bust of the late 1990s and early 2000s experienced significant risk:

• The US stock market was highly speculative during this period.

• Some investors earned impressive gains on their IPO investments.

• Other investors incurred substantial losses after tech stocks plummeted.

Conduct your own due diligence before investing in an IPO. Although limited information is available on a company going public, you can refer to the company’s preliminary prospectus, called a “red herring,” to learn about the following:

• Target market

• Competitive landscape

• Company financials

• Company management team

• Who is selling shares in the offering

• Who currently owns shares

• Expected price range

• Number of shares to be issued

• Potential risks

Participation in an IPO

Investors who participate in an IPO agree to purchase stock shares at the offering price before the shares start trading on the secondary market. The lead underwriter and the issuer focus on many factors when determining the offering price, including the interest expressed by potential investors.

If you want to invest in an IPO, determine whether your brokerage firm offers access to new issue equity offerings and what the eligibility requirements are:

• Higher-net-worth investors and experienced traders who understand the risks of participating in an IPO generally are eligible.

• Because demand often exceeds the number of available shares, individual investors might have difficulty obtaining IPO shares.

• Due to the scarcity value of IPOs, many brokerage firms limit who can participate.

• Investors might be required to hold a substantial amount of assets with the firm, meet specific trading thresholds, or have a long-term relationship with the firm.

Although participants in an IPO can sell their shares when desired, many firms will restrict their eligibility to participate in future offerings if they sell within the first few days of trading:

• Selling IPO shares quickly is called “flipping.”

• Most brokerage firms discourage flipping to maintain stable market prices, avoid volatility, and ensure shares go to long-term investors.

• Flipping signals high speculation, disrupts orderly trading, and can lead to penalties, including fines and 30- to 90-day bans from participating in future IPOs.

*This information is for educational purposes only.

Let me know in the comments which personal finance topic I should write about next!