IPOs and Underwriting
What is an IPO?
An IPO stands for Intitial Public Offering. Basically, an initial public offering occurs when a company that was previously privately owned decides to sell shares of stock in order to raise money. The company generally finds an investment bank to help them carry out the procedure. Generally, the company seeking an IPO is smaller and younger and needs capital, but large privately held firms have also been known to do this.
What is underwriting?
Underwriting is closely related to an initial public offering. Investment bankers need to underwrite a company in order to get investors to purchase shares of it for the first time.
Should you invest in an IPO?
IPOs are inherently very risky business. As a result, there is potential for huge gains and huge losses. Since the company is starting to be listed on an exchange, there is no historical market data for it and very little to research. On the first day, the stock could gain hundreds of percentage points or lose hundreds of percentage points.
Points to Look out For
If you do decide to invest in a company's IPO, at least look out for some key things.
- Most companies performing an IPO submit a prospectus detailing their benefits and disadvantages. They also discuss what the money from the IPO will be used for and their future plans. This document is a good guideline, although be wary that it is written by the company and is therefore inherently biased.
- Make sure that the underwriting firm is strong. Generally the big investment banks take on big customers that are more likely to be solid months and years after the IPO. For example, Goldman Sachs is one of the most prominent investment banks, and they can afford to be picky when choosing which companies to underwrite.
- Try to research the companies well. Even though they have no previous market record, you can still look into what they have done since their inception. This will likely be harder than for a public company because they are not required to disclose all of their financial details.
Example of a Strong IPO
There are tremendous upsides to IPOs, of course, that may far outweight the risks. If you bought one share in the company pictured below, it would have cost you $21 and be worth more than $8,000 today. The vast majority of people who purchased shares in it became rich very quickly. Don't be afraid to invest in an IPO, but always be cautious of which one to choose.
Picture from Microsoft, 2004