What is an Initial Public Offering?
The term IPO stands for Initial Public Offering, which has gained popularity from the tech bull market of the late 1990s. It refers to a private company’s first attempts to sell its shares to the general public. These shares are offered to new investors and are freely tradable on stock exchanges. The offer can be made either to the general public or to institutional investors such as pension funds. The companies issue new shares to raise new money. Existing investors can also put their shares on sale.
Companies can announce an IPO for a variety of reasons such as the following:
- The company wants to access capital markets to raise money for organic growth, acquisitions or to pay off debt.
- The company wants to improve its reputation in the market and is listed on a stock exchange that offers a great deal of transparency.
- The company’s private owners want to either reduce or exit from the market completely. This way they use an IPO to find buyers for their shares.
How to Participate in an IPO?
IPOs are popular as they provide a large number of investors, the chance to back a company that is entering a new stage in its life. When the general public participates in IPOs, they essentially buy shares before they hit the stock market, Retail investors account for a large percentage of new shareholders when many companies first float on the stock market.
To Participate in an IPO, you have to follow some basic steps.
Getting Information About An IPO
Nearly all companies are required by law to announce their plans to list in the stock exchange. Even though the details may vary from country to country, it generally consists of how much money the company wishes to raise, as well as the biggest existing shareholders. After determining the price range for the float, companies typically make another announcement to the stock market.
To get detailed information on the companies you are about to invest in, look at their admission document or prospectus. These will give you an insight into the company’s financial history, business strategy, risks, legal issues, and others. You should also find an in-depth analysis of market trends, accounting policies, and tax implications. Never rush to place an order and always make sure to read the prospectus, factsheet, and other supporting documentation that come along with them.
Offer Period Stage
The offer period usually lasts anywhere from a few weeks to a month. The company does not possess a firm price at this stage. Use this time to study the documentation and subsequently place an order if any aspect of the company’s financials looks profitable. IPOS also state their minimum investment level at this stage. Investors are asked to confirm whether they have gone through and understood the contents of the prospectus before they invest, especially the key risks as stated by the company itself.
Share Allocation Stage
The price of the IPO is usually published within two days of the offer closing. If the offer is oversubscribed, there a chance you won’t get the full desired allocation of shares. In case the IPO offer is only restricted to institutional investors, your first chance to buy shares will be when the company starts officially trading in the stock market.
The following IPO checklist highlights some of the issues that investors should consider before making the final investment decision.
- Are the owners of the company selling all or part of their stake in the IPO?
- Is there any participation from venture capital firms or financial institutions in this IPO?
- Is there any easily explainable long-term strategy for ensuring commercial growth?
- Which sector does the company operate in and what is the growth prospect relative to the sector?
- Will the funds from the IPO be allocated to growth funding or will be used to pay off existing debt?
- Does the company enjoy tax benefits?
Additionally, one should ensure that they have taken the following actions.
- Reading the factsheet and prospectus in detail.
- Deposited money in their account before applying for shares.
Red Flags to Watch Out for in IPOs
There are certain red flags to watch out for when investing in IPOs, spread across different aspects. We shall now go over them one by one.
- The management quality of the company is key and possessing an established track record in a particular sector is crucial.
- The company’s shares should not feel overvalued to you.
- Deals that are made between 2 parties along with a pre-existing relationship is generally unfavorable.
- The company should not merely raise funds to plug underinvestment.
- Any recent acquisition that the company makes needs to be explained in detail to all investors.
Risks Associated with IPOs
- Documents are not reliable: The prospectus and the admission documents are meant to provide a detailed insight into the financial situation and objective of the company in question. Yet there have been several instances where investors have been disappointed after the IPO. Thus it is important to read the documentation to get be aware of every last detail, such as a lack of patents to protect intellectual property, or a legal case.
- New market entrant: There are often unimaginable amounts of expectation attached to new market entrants in the stock market. As a result, share prices can plummet upon the slightest of bad news. This may be the result of the sales figures or contract wins being not as strong as the management commentary first suggested.
- Lack of track record: A large number of companies have little to no track record of trading, which means there’s little data to go by when investing. There are companies that entice investors with the promise of large dividends. However, they subsequently fail to deliver the promised cash returns to shareholders for a variety of reasons.
Investors always have to remember that IPOs carry a high degree of risk. Regardless of this fact, an IPO can be likened to a company entering a new stage in its life, which also creates value for the owners, customers, and employees.