Introduction to Trading IPO’s

There are basically two types of companies: private and public. A private is just that, a company that is wholly owned by a group (or individual), that makes the decisions for the company without having to get approval from any sort of outside agency, i.e. board.  A public company is a company that has issued stock on at least one exchange that is available to the general public. Publicly traded companies are owned by the shareholders and therefore management must disclose their actions to their investors, usually through meetings open to all once a quarter. In this article we will go over the process for transitioning from a private to public company, how one can invest in IPOs, how its initial price is dictated and rules for investing in IPOs.

First thing we will go over is how a private company actually becomes a public traded company and why they would do it. Most private companies looking to expand need some sort of large capital infusion that can be difficult to acquire through traditional lending measures. One resource that all private companies have is that they can sell ownership in their company. Although this will dilute ownership, the capital infusion can help the company expand, pay off any debt as well as give them access to lenders that they would not been able to speak with before becoming public (because of the increased scrutiny a public company has to go through). Going public also raises the exposure and prestige of a company which can attract new clients as well as new employees. Being public also gives the company increased financing capabilities since they can use stocks and convertible debt. There are some disadvantages for going public as well. Companies will face significant fees for legal, auditing and accounting services that will have to be done. They will also decentralize the management decisions of a company since there will be an increase in the number of owners who can have a say. Also, a publicly traded company will have to open its books since they are required to file financial and pertinent business operations on a quarterly basis.

The process of becoming a publicly traded company is done through underwriting by an investment bank. The first thing to a private will do is hire an investment bank that will basically be a bridge from the company to the investing public. Underwriting is the process of investment banks raising capital from investors for companies that are becoming publicly trading companies. Companies do have the option of selling their shares themselves without an investment bank but then they would not be listed on an exchange. The biggest investment banks around today are Goldman Sachs, Credit Suisse and Morgan Stanley. Once the issuing company and investment bank have decided how much money will be raised and the type of securities they plan to offer, the investment bank will either make a firm commitment or best effort. Usually the investment bank and issuing company will structure the deal whereby the investment bank buys all the shares then resells to the public, which is a firm commitment. But there are deals that are done on a best effort basis whereby the investment bank will sell the shares but makes no commitment to the amount of money that will be raised. The amount of interest on the deal will determine which route to go (the hotter the IPO, the more likely the investment bank will make a firm commitment). Many times their will be multiple underwriters (or investment banks) as a way to spread the risks. Once the structure of the deal is in place, the next item is to file a registration agreement with the SEC. The registration agreement will contain financial statements, insider holdings, legal and debt problems, basically all pertinent information on the company and their business. After that, the SEC invokes a cooling off period where they investigate the company to make sure all relevant information has been disclosed.  During the cooling off period, most issuing companies put together a red herring or prospectus and go on a road show to generate interest in the offering. The next step is for the investment bank and issuing company to come up with a date for the offering which will based on the interest generated from the prospectus as well as market conditions. It is not unheard of for a company to delay their IPO if market conditions are not favorable for their offering.

Generally, investing in an IPO can be difficult for individual investors. The whole idea behind IPOs is to raise capital for new companies, which means they are looking to court institutional investors with larger pockets. Now this doesn’t mean that individual investors are completely blocked out of the process of investing in IPOs. For an individual investors to participate in an IPO they will first have to have an account with one of the underwriters. There is no getting around this if you want to get the offering price. If you do have an account with one of underwriters, it still doesn’t mean that you will get a piece of the deal. Usually IPOs have a lot of interest from buyers, so most underwriters give their best clients right of first refusal for shares. If it is a particularly hot IPO, the underwriters have a tendency to only give sellable shares to their best salesmen. Another factor in determining the availability of IPO shares to individual investors can depend on past history. If the underwriter wants to see its clients hold a particular IPO for a period of time and you flipped your shares within the first week or two, you may never be able to get in on an IPO with them ever again. Again this is just if you want to get in on the ground floor. Once the IPO starts trading in the secondary market, anyone with a stock account and the available funds can invest, but it very well could already made its run. In the end, the best way to get in an IPO is to already have an account with one of the big underwriters and be a client in good standing who is working with one of the firm’s better brokers. Another thing to remember is that it is possible to short an IPO although not easy. Since the stock is new, it may be hard for your broker to lend you the shares to short.

There are a couple different ways that IPOs are priced: either through mutual discovery or via a Dutch auction. Mutual discovery is the process by which both the company and investment bank decide what will be the optimum price for the IPO in order to raise money. This will be based on the general interest in the IPO as well as the amount of capital targeted. It is not usual to see IPOs come out severely undervalued in order to generate more interest (as well as volume in the security). A Dutch auction is the process of taking all bids first and then determining the best price for the shares. Probably the most famous Dutch auction in recent memory was Google’s.

Some general rules for IPOs are to stay on the same side with Wall Street, watch your investment in an IPO and be aware of the current IPO cycle. The first rule, stay on the side as Wall Street, may seem self evident but many people try to fight the tape. If there is widespread investment by Wall Street firms in an IPO, it is usually a good idea to stay in as well. There are numerous studies out there that have proved the IPOs have underperformed the market as a whole. IPOs tend to be trendy picks with people looking for a fast buck. It would be wise to watch your IPO quite often as it very well could sell off big after the holding period. Last but not least is to be aware of the IPO market. Back in the 90s, IPOs were hot and saw huge gains on their first day, sometimes even over 1000%. But in the early 2000s, IPOs did very poorly and the amount of IPOs that can out during that was significantly less. Market conditions also play a role in when a security will come to market. Not surprisingly, there were not many IPOs during the crash of 2008.

In the end, IPOs are an exciting and potential profitable way to invest in new companies. But also know that brokers know this and use it to their advantage.