IPOs – what are they and how can I profit from them
Most companies require money to grow. Typically, sources for this growth capital are local banks or a small set of private investors. As a company continues to grow, its capital requirements become greater and typically outstrip local sources. Enter initial public offerings (IPOs).
A company can decide to offer shares of its firm to the public via an initial public offering, or IPO. Through an IPO, companies can offer entirely new shares to the public. Frequently, along with these freshly-minted shares, a large investor or the founders of the firm sell their existing holdings.
Companies offer their shares publicly for a variety of reasons, including:
- Financial engineering: Proceeds from an IPO can be used to pay off large debts, restructuring a company’s finances, and freeing up profits.
- Growth capital: Going public gives firms a strong infusion of growth capital as new money comes into the firm.
- Diversify shareholder base: Some firms need to raise a lot of money, and having a broad group of shareholders makes fundraising easier. Going public gives firms access to millions of potential investors.
- Founders get liquid: In financial circles, an IPO is called a “liquidity event” since it provides an exit and a monetary windfall for founders of a firm (who sell their shares to the public).
- Ride the media hype: Companies going public grab media attention and can use this to create “hype” about new products or services.
- Stock as currency: Stock options can make employment more attractive by extending ownership opportunities to employees. Further, public stock can be leveraged to launch competitive acquisitions of other firms.
How IPOs Work
The IPO process means much financial research and forecasting. Companies also have to comply with legal regulations. Accounts are audited for accuracy; boards are reviewed and, in a crucial step big, an underwriter has to be contracted. (Think, Goldman Sachs, Credit Suisse First Boston and Morgan Stanley.) Here’s what happens.
- Underwriters come in: They work to set fair market value and initial stock price, generate interest in the company and the IPO and help develop the prospectus
- The prospectus is drawn up: The prospectus, a formal explanation of the company’s financial status, future plans and risks, is reviewed and approved by the SEC
- Investment banks commit: They buy a certain number of shares from a company during the IPO process. In turn, the investment bank creates demand among its clients (both professional and individual investors).
- Marketing commences: The SEC restricts how and to whom companies can discuss or promote their deal before it happens. Making mistakes in this quiet period can mean a long delay, spelling disasters for companies that are dire need for the capital. In return for their fundraising efforts, investment banks can take in around 7% of the total proceeds from an IPO. That’s big money, so investment banks compete heavily for IPO clients.
Party Like It’s 1999:
The stock market of the 1990s generated serious wealth, in large part due to the rise of technology and the Internet. By October 1999, the top six tech stocks — Intel, Microsoft, IBM, Dell, Lucent and Cisco boasted a combined value of $1.65 trillion, a full 20% of the GDP.
Web-based companies like GeoCitites, eToys, Pets.com and Globe.com were trading high; the eToys IPO, priced at $20 a share, soared to $85 within minutes. theglobe.com, an online community, had a record-setting IPO that rocketed up to 606% on its first day of trading.
eToys was bankrupt in two years and theglobe.com was delisted from the Nasdaq.
The internet bubble burst.
IPOs are again the new “in thing” for internet-based companies. Groupon,LinkedIn, and Zynga have all recently had IPOs. Technology investors are anxiously awaiting the monster Facebook IPO, probably occurring in early 2012.
And remembering history, pundits are nervous that investors will get stuck holding the bag if this bubble bursts.
Getting in on the $$$
IPOs have a checkered history — most don’t perform particularly well. But the few that do, spell huge profits for investors. It’s this allure of massive gains that draws investors to these yet-unproven stocks.
- Look for “hot” IPOs: Find out if corporate insiders believe the market is willing to pay at least full price for the companies in the industry. Use this clue in evaluating investments you currently hold or you’re considering in the same industry.
- Invest in IPOs of companies with a future: Rather than attempt a one-day-price-flipping-instant-rich scheme, go for the long term. If you believe in the company’s strategy, management, and products, stay with it. Microsoft’s stock prices jumped and jostled like a bad roller coaster ride. Then look what happened. However, if forward-looking investors stayed the course, investing during the volatile 1990s, they would be coasting along in the tunnel of love right now, sipping mixed drinks on some Caribbean
Few companies make it to IPO because the arduous requirements and expensive process weed out many firms. The few that make it through can be this generation’s big winners. Or, they can be total flops. If an investor wants to invest in an IPO, she should do it just as she invests in any other stock: with an objective eye for the future.