Getting an IPO at the right time can mean massive returns to your portfolio if you play it right. But before diving into every new company that shows up on the NASDAQ, it’s important to understand how IPOs work, why a company would go public, and the pitfalls you as an investor should know.
What is an IPO?
An Initial Public Offering (IPO) is created when a private company wants to attract outside investors to grow, pay off debt, or fund research. The private company may have had investors or funding before, but these are usually from a select few sources like friends and family, angel investors, or startup incubators.
Anyone who invested in this company before it went public had a share in some form or another. The founder may have given up a percentage of ownership, profits, or some other means that ensured whatever investments were made received something of value that was expected to grow over time.
IPOs are not the same as this, as they allow anyone with access to purchase shares and have a small piece of ownership. In addition, while private companies can offer equity or a percentage of the profits, their valuation isn’t beholden to any sets of regulations. In an IPO, the company must submit mountains of paperwork showing its financial data, projections, and whatever else the investment bank they’re working with requires before it can go public. The investment bank the company works with helps establish its valuation based on complex data like assets, revenue, and in-depth financial analyses.
Once the initial valuation is established, the date for the IPO and initial share price are set. The company then registers with the Securities and Exchange Commission (SEC) and waits for approval. When the approval is done, the company can then go public.
How Does an IPO Work?
As you can see from the first section, IPOs are a tremendous task for any small business to take on, so an outside expert team is typically brought in to help make the IPO as easy as possible.
These experts, known as underwriters, are hired to help move things along. They tackle the nuances that must be adhered to so that the company won’t get dinged by the SEC. Once the IPO goes through, these underwriters will be handling selling the shares and distributing dividends, should there be any.
Just because the company establishes an IPO doesn’t mean anyone can jump on it from day one. The company will usually offer the first round of available shares to previous investors, employees, friends and family, or other “VIPs” before releasing the remaining shares to the public.
A Few Things to Consider Before Investing in an IPO
While everyone wants to find the next Tesla or Amazon and get in as early as possible, there are a few things investors should know about IPOs.
- IPOs are incredibly risky – Just because a company goes public doesn’t mean it will remain solvent. Many companies launched an IPO only to end up as a penny stock or even delisted from the stock exchange entirely, turning your investment into a loss.
- IPOs can turn a bad situation worse – Public companies are accountable to their shareholders above all and must keep meticulous financial records that are then released. Consequently, having an inexperienced Board or a rogue founder can turn a “quirky” business into a disaster for your investment. Some companies can’t handle the detailed work and public scrutiny and may sell to a competitor or go back to being private.
- Early investors won’t be holding the bag – The SEC requires all “first round” (the VIPs mentioned above) to keep their shares for a certain period of time, usually around three months. After that, many initial investors will sell their shares and move on, making the stock take a nosedive, albeit (hopefully) temporarily.
Ready for More?
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