What are IPOs and can I invest in them?

Left and right, people seem to be getting rich from Initial Public Offerings, or IPOs. Invest in the next Facebook or Apple right before it goes public and watch the profit flow in — how hard could it be?

Not so fast. IPOs tend to be well scripted affairs between the company issuing stock and those buying it. Canadians can legally participate in IPOs listed on the Canadian Stock Market, but cannot participate in US IPOs without some hurdles. Moreover, it may not be the best investment.

What is an IPO?

An Initial Public Offering is the event when a company transitions from a private ownership to a public ownership. The company is able to raise capital by issuing shares of stock to the investing public. The shares produced by the company allow the general public to participate in the investment market.

The initial investors in a private company are then able to earn a significant profit as their private shares are converted to public at the price offered on the market. The company, in turn, is able to access substantial funding to fuel further expansion.

Taking a company from private to public also comes with a number of required disclosures and transparency measures. The Canadian Securities Administrators, or CSA, governs publicly traded companies in Canada. The Securities and Exchange Commission (SEC) is the United States counterpart.

As soon as a company is listed on a stock exchange, individual investors can start buying their shares. Some of the largest IPOs have garnered billions of dollars in funding. Alibaba, for example, raised $25 billion during their IPO in 2014.

Advantages of an IPO for a company

• The ability to raise capital by selling shares to the public

• Increased transparency (i.e. requirement of quarterly reports) generally allows for more favorable credit terms

• Many companies can offer stock as a part of a compensation package to attract higher caliber employees

• A public company sees a big lift in public image, often translating to better performance

Disadvantages of an IPO for a company

• Very expensive; IPOs are really only for the largest and most successful companies

• Requirement to disclose earning statements and other documents that many not benefit the company

• Shareholders have voting rights and can exert more influence over a company, sometimes to the chagrin of its founders

• Moving share price often leads companies to chase profits over mission, product quality, or other items

How to prepare a company for an IPO

In order to initiate an IPO, the company in question has to perform a number of crucial and complicated shifts in management, governance, and transparency. The company must form a board of directors who are looking out for the interest of the shareholders.

It also needs to go through underwriting with a chosen financial partner, often an investment bank. The underwriter will go through the financials of the company with a fine tooth comb before applying for the IPO with the relevant regulatory authority, such as the CSA or the SEC. That underwriter will then work to attract initial investors in the business through a series of presentations and sales meetings.

These meetings are intended to do a number of different things. First, it will give the issuing bank and company a good idea about the appetite for shares of their business. Second, it will generate buzz around the stock as the day of the IPO approaches, likely increasing the IPO pop that companies hope to experience.

"Some of the largest IPOs have garnered billions of dollars in funding. Alibaba, for example, raised $25 billion during their IPO in 2014."

How can I invest in an IPO?

IPO stocks are often very popular and demand almost always outdoes supply. That’s because IPOs are expensive and as such, companies have their own interest in ensuring that the shares go up in value. To achieve this, they rely on large and/or institutional investors to buy the shares immediately after the stock is available on the market. This makes it very difficult for individual investors to get involved.

Moreover, Canadian investors are not able to directly participate in IPOs based on US stock exchanges. Canadian investors are able to buy into Exchange Traded Funds or Mutual Funds in the United States that may take part in the IPOs of various companies. It’s important to note that there are a number of tax implications of doing so, both in Canada and in the United States.

Nevertheless, there are two ways you might be able to invest in an IPO: more commonly, either through a brokerage firm or quite rarely, directly through the underwriter. If you are an important client of a brokerage firm that has been roped in as one of the broker dealers responsible for selling shares of the IPO to individual investors, you may be able to secure access to the shares the instant the IPO starts trading on the market.

In the second option, if you have a relationship with the underwriter or the issuing bank (the bank who is bringing the company public), you may be able to participate in the IPO. For the vast majority of investors, however, this is not possible.

Important IPO terms to know before investing in an IPO

Common stocks: When a company goes public, they sell shares of common stock. By purchasing shares of the common stock, shareholders are effectively purchasing small units of the company’s ownership and are now eligible to receive dividends.

Issue price: Also known as the offering price, issue price is the price at which investors can purchase shares of the company before the company goes public and begins trading on the open market.

Price band: Price band is the price range in which different groups of investors are allowed to bid for the IPO shares. This range is different for different groups and is set by the underwriter and the company.

Lock-up period: Lock-up period is a pre-defined time frame after the IPO when investors who own equity stakes in the company cannot sell their shares holdings. This is implemented in the form of a lock-up contract between the underwriter and insider investors to make sure the stock prices are allowed to stabilize immediately after the company goes public. It can last from anywhere between 3 to 24 months.

Flipping: The term flipping is used to denote the activity of buying and quickly reselling within a few weeks of purchasing to earn a quick profit.  Flipping is generally discouraged by most brokerage firms.

Direct listing: A direct listing is when a company forgoes the underwriting process altogether and becomes public by directly allowing their insiders to sell their shares on the open market, without raising new shares. This can decrease the cost of the IPO but increases the risk for the financing bank.

SPAC: Special Purpose Acquisition Company (SPAC), also referred to as “blank check” company, is a company created with the sole purpose of raising money to acquire private companies looking to go public.

Are IPOs a good investment strategy?

All in all, IPOs can be quite profitable. But, are they a good investment strategy? As with any investment, it is crucial that you build a balanced, well-diversified portfolio. If you have a solid foundation of other assets, retirement accounts, and liquid cash on hand for emergencies, an IPO can provide opportunities for growth that simply are not available in other investments.

However, it’s important to recognize that IPOs are volatile and far more likely to result in losses than a normal investment. While most IPOs will experience a pop on the first day of trading, there can often be holding requirements placed on initial investors. This means that you are required to hold a certain number of shares for a set period of time. That means you could be stuck holding onto a stock long after its pop has receded and the stock price has taken a downturn.

Final thoughts on IPOs

Both the United States and Canada have a plethora of financial education options for consumers. In Canada, the CSA offers investment basics explanations designed to help first time investors. In the United States, FINRA offers a variety of different calculators, how-tos, and important things to look out for.

It can be confusing to invest in IPOs as an individual investor. This is one of those things in the financial world where it truly helps to have a trusted investment banking partner to help sort out the particulars. If you’re ever unsure, try KOHO Extra free for 30 days, and set up a chat with our Financial Coach to help you understand what products and services are available to you.