5 Tips for Investing in IPOs

IPO or Initial Public Offering is the first time the stock of a company is sold to the public when it makes the switch from a private company to a public limited company.

IPOs were all the rage back in the dot-com mania of the 1990s when investors were pretty much guaranteed doubling or tripling of value when they purchased tech IPOs. While some companies like VA Linux saw huge first-day gains but eventually ended up disappointing investors, later on, those who had the foresight to get in and out quickly were majorly successful.

The trend of instant doubling of tech IPOs may have ended, but there is still plenty of money to be made in IPOs even though the focus has shifted. Investors aren’t interested in flipping stocks anymore. Instead of intending to make money off a stock’s initial bounce, they tend to pick stocks that seem to have good prospects in the long run.

To participate in a company’s IPO, you first need to find a company that is about to go public. You will need to be registered with a brokerage firm, although this can be done very simple nowadays with online stock trading sites which make it very easy for the layperson to buy and trade stocks.

If you are interested in purchasing an IPO, you should consider a few things before you take the plunge.

Be Thorough in Your Research

Unlike most publicly traded companies, private companies may not have a lot of information about them on record. While most companies try to fully disclose all the information regarding their business and future projections, it’s worth remembering that this data is still provided by them and not an unbiased third party.

This is why it’s important to do as much of your own research as possible. Search online for any and all intel about the company, it’s competitors, financing, past press releases, and the overall climate of the industry. This may help you gather crucial information that would help you decide whether to invest or not. The worst-case scenario would be if you uncover that the company’s prospects are being overblown and that it may not be worth investing.

Pick a Firm with Strong Brokers

A company that has a strong underwriter can be assumed to be far less risky than those with smaller brokerages. That isn’t to say the latter can never be trusted, or that big investment banks never go with flops, but they can afford to be a lot pickier with whom they choose to underwrite. Quality brokerages, like Goldman Sachs, typically are associated with quality and their reputation helps them bag the best IPOs.

That’s not to say you should never go with boutique brokers because their smaller client base makes it easier for individual investors to purchase pre-IPO shares. Large brokers, on the other hand, do not allow short-term investors to buy IPOs – those are reserved for long-standing, established, clientele who typically have a high net worth.

Always read the Prospectus

Yes, you shouldn’t base your decision to invest in an IPO solely on its prospectus, but it is worth a perusal. You can request the prospectus from the brokerage firm that’s facilitating a company’s transition to the public. It is a rundown of all the risks and opportunities of the company, along with the proposed use for the money raised by the IPO.

The proposed use is something you should consider carefully. If they are intending to use it to repay loans or buy equity from founders or private investors, it’s not a promising sign as it indicates that the company cannot afford to pay its loans back without issuing stock. On the other hand, a company that intends to use the IPO money on avenues such as research, marketing, and/or expanding to new markets projects a far more promising diagnosis.

However, you must also be aware of a prospectus that seems to promise overly optimistic future earnings. Overpromising and underdelivering are one of the biggest mistakes made by companies offering IPOs.

Proceed with Caution

You should always take everything with a grain of salt when it comes to the IPO market because a lack of available information makes for a lot of uncertainty. Therefore, it’s important to always be cautious.

This is especially true when your broker recommends an IPO because it is an indication that most money managers and other “big money” institutions have passed on the underwriter’s offer to sell the stock to them. In such a case, individual investors are likely getting the “bottom feed”. This is also exacerbated by the fact that the average investor is often only given the opportunity to invest in risky avenues as brokers tend to save the promising IPOs for their favored clients or high rollers.

Even if you want to play the long game, a good IPO can be hard to come by as they present risks unique to them when compared to regular stocks.

Consider Waiting Until the End of the Lock-Up Period

The lock-up period, typically lasting between 3 to 24 months, is a legally binding contract between the underwriters and the company that forbids investors from selling any shares of stocks for the stipulated time period.

This is done to protect potential investors from losing money on a stock that is overinflated during its initial offering – as a lot of them can be. As time goes on, the company’s stock would come down and find itself at a more natural rate. The overvaluation is noted during the lock-up period, which is why investors cannot sell their stocks for such high prices at such a time.

This is why it may be a good idea to wait until the lock-up period ends. If the stock holds up even after that, it seems like a good indication that the company has a positive and sustainable future – especially if insiders decide to stay on. Let things play out a bit before diving in. A good company will still be a worthy investment a few months down the road.

A Final Word

IPOs are a pretty risky investment, however, that is not to say you should never invest in them at all. Clearly, there are many who have made handsome gains by buying the stock at IPO prices in a number of companies.

Successful companies go public all the time, but narrowing down the ones with the most potential is no easy task. You would do well to remember that the IPO market doesn’t play by the same rules as the regular stock market. Investors who are up-to-date and have their fingers on the pulse do far better than those that are too trusting or ill-informed.