A Beginner’s Guide to IPOs

Initial Public Offering

Positive momentum in the stock market can result in numerous IPOs being launched by companies looking to cash in on investor goodwill and general optimism – potentially leading to a lot of profit-making opportunities, as well as a great deal of excitement! However, as is true for most things, it can be easy to get caught up in the hype and thrill of it all. Investors tend to rush into such investment opportunities, especially if it is a company or brand that is well known and loved.

Over the years, we’ve seen IPOs launched with a great deal of fanfare and enthusiasm only to see them crushed soon after their opening day. Uber – the multibillion-dollar unicorn that has become a household name, is set to launch its IPO on Friday, May 10th, ringing in what many forecast to be a busy season for tech companies making the crossover from the safety of tech incubation to the cut-throat capitalism of Wall Street.

With Uber’s IPO just a few days away right on the heels of the Lyft IPO, as well as many recent or upcoming IPOs of other prominent companies such as Slack, Pinterest, and WeWork, it may be as good a time as any to learn about the basics of IPOs to avoid getting burned.

What Exactly is an Initial Public Offering?

IPO, which stands for Initial Public Offering, is the process by which a previously unlisted company becomes a public company. Most companies that hold IPOs are privately held companies that have gained traction but need outside financing for continued growth. Private companies often have only a handful of shareholders, such as early investors (family, friends, and founders), high net-worth individuals, and angel investors. Once they conduct an IPO, they go public and, therefore, can raise the capital they need for growth and expansion by selling shares. The shares that are issued can generally be traded in an open market and sold to other investors via a secondary market.

Why Companies Go Public

The first and foremost reason why a company decides to go public or hold an IPO is to gain access to new sources of capital. It’s much harder for a private company to acquire funding or borrow money than a public company. Moreover, shares held by founders, employees, and private investors usually don’t have as much value while the company is private. However, with a public company, public disclosures and accounting oversight make the borrowing process much easier. Furthermore, shares tend to skyrocket after an IPO, giving investors the opportunities they seek to make handsome returns. Capital that is raised can then be channeled towards business opportunities and for funding current or future operations.

Other companies go public to have their stock listed on a stock exchange. Becoming a publicly traded company is a sign to the world that the company adheres to a series of strict federal regulations. Moreover, it represents a transference of company ownership to a large group of shareholders. Therefore, the company can easily acquire more investors and spread company ownership to more individuals or entities. This ultimately reduces the overall risk, debt, and cost of capital to the company. Moreover, it can attract the kind of talent that it would otherwise not be able to with a salary alone by promising shares and equity as part of employee compensation packages which is something more and more people look for in their careers.

Risks and Benefits of an IPO

Going public or holding an IPO seems to be the end goal of new and thriving start-ups. While most industry giants today owe their prosperity to having a strong IPO, the process itself is riskier than it seems. Here we look at some of the risks and benefits of an IPO.

Benefits

Increased Capital: The most obvious benefit of holding an IPO is gaining access to more capital. Investors of public companies can purchase and sell their shares at their convenience. This is primarily because shares of publicly listed companies can always find buyers, which isn’t always the case for private companies. This liquidity makes it easier for investors to part with cash to buy shares, thus giving the company access to more capital and funding opportunities.

Reputation and Brand Name: Once a company is listed on a stock exchange, everyone from suppliers, employees, and stakeholders to competitors and general investors begin to view it in a different light. Being listed usually means being not just larger but more efficient and better managed than a private company.

Higher Valuation: Investors are in constant competition to acquire the shares of the most valued companies. This competition creates demand for shares which in turn drives the prices of shares higher. Since share prices put a price tag on public sentiments about a firm, a price increase translates to a higher company valuation.   

Risks

Loss of Privacy: Once a company becomes public, it is required to disclose its financial results periodically. However, once a company starts to give out information about its inner workings and strategies, it can slowly begin to lose its competitive edge. Competitors can quickly reverse engineer the company’s financial results and make a fair estimate of the company’s operational strategy.

Loss of Control: Going public is a risky undertaking for business owners. If owners or promoters dilute their holdings too much, they can risk competitors and investors buying majority shares of the company which they can use to conduct a hostile take-over. Over the years, many business owners have lost their businesses in such a manner.

Performance Pressure: The stock market is notorious for being unsympathetic to and not tolerating declining performance. Since public companies are required to report their financial results every quarter, a lower-than-expected performance can trigger a massive sell-off which may translate to reduced stock prices. Therefore, many public companies become short-sighted towards future growth and focus only on making investors happy – a potentially detrimental strategy for any business large or small.    

Key Factors to Evaluate Before Investing in an IPO

Investing in an IPO can be a lucrative opportunity to make huge returns in a short amount of time. However, with a large majority of companies failing after their IPO, investors are left with the dilemma of whether or not to invest in an IPO. While it’s challenging to arrive at the right decision, here are a few factors that investors can keep an eye on to make sure that their investment efforts remain fruitful. They include:

  • Existing competition in the market: Is the company’s product unique? Are others doing the same thing? What are the differences between them and others operating in the same (or similar) space?
  • The company’s current management: Who is in charge? Has there been any news of company politics? What track record do the founders have? Do they jump ship or slowly grow their individual endeavors?
  • The company’s past performance: What have they done well, and where have mistakes been made? How are they doing overall in terms of revenue, market penetration, marketing, and growth?
  • What individual metrics can you highlight – both good and bad – on the company’s user growth, new products, or roadmap milestones that have been met or missed? Are these metrics trending upward or downward?
  • Market demand for the IPO: What kind of institutional response has the potential IPO received in the public media? What are people saying? Is everyone saying good things or are there glaring red flags that reliable analysts have raised regarding the IPO?
  • The stage of the company – Are they in their initial growth stage, or have they marched towards mass adoption? How far are they from maturity, saturation, or potential decline? Answers to this question can give you a guideline for how much room there is for the company to grow – not just in terms of dollars but in terms of years as well.

Conclusion   

Although the allure of making huge returns within a short amount of time is something everyone looks at, investing in an IPO is a pretty huge – and sometimes complicated – undertaking. Things can go exceptionally well or unexpectedly bad. Therefore, as a budding investor, it’s always a good idea to conduct proper market research and take into consideration all of the factors above to allow for the best possible investment opportunity.

If this article was of interest, and you’re ready to get more acquainted with the trading and investing space, check out our online Trading MasterClass for more.

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