No matter how long you have been investing, growing your portfolio is undoubtedly at the top of your to-do list. While there are many great ways to maximize your gains, one popular strategy involves investing in companies that have recently gone public.
When researching privately owned businesses that are preparing to list their shares on stock exchanges, you will encounter the acronym “IPO” quite often.
IPOs — initial public offerings — are all the rage these days, as they are viewed as a great revenue-generating opportunity. Although this can certainly be the case, investing in IPOs can be a risky proposition.
To help you decide whether IPOs are a good fit for your portfolio, let’s take a deep dive into what they are, how they work, and some key terms you need to know.
What’s an IPO?
An initial public offering is when a privately owned business makes its shares available to the public for the first time. Sounds simple enough, right?
For the most part, it is. If a business announces an IPO, it means that it is going to list its shares on a stock exchange, such as the New York Stock Exchange (NYSE). Once listed, stocks are free game for anyone from casual investors to professional brokers.
IPOs are thought of as money-making opportunities. This is largely because many companies experience a surge in stock prices once they go public. However, IPOs do carry a great deal of risk and may deliver inconsistent returns over time. This is especially true if a company announces an IPO prematurely.
How Does an IPO Work?
From the investor’s perspective, an IPO seems quite simple. A company goes public, lists its stocks on an exchange, and gives you the opportunity to buy shares.
However, for businesses, going public is a tedious process. To go public, the company must file a variety of financial disclosures and other paperwork with the Securities and Exchange Commission (SEC). The documents will also include a prospectus, which is what the company intends to use to solicit investors.
Due to the complexities associated with filing an IPO, many companies partner with an investment bank, which serves as an underwriter. The investment bank will provide guidance to the company going public, assist with document preparation, and help set the initial price for the offering.
After the company and its underwriter set the initial price for the IPO, the underwriter will issue shares to existing investors. Then, the company will make its stock available on a publicly accessible stock exchange.
What Is the Purpose of an IPO?
An initial public offering gives the general public a chance to invest in a company. However, this is not the primary purpose of an IPO. The main reason that companies go public is to allow early investors to cash out and obtain a return on their investment.
Typically, many of the initial investors will sell their stakes so they can move on to the next revenue-generating opportunity. This is especially common if the business going public is a relatively new venture or start-up.
The popular show “Shark Tank” is a good illustration of the changing of the guard that occurs during an IPO. When a company is in its infancy, speculative investors (like the hosts of “Shark Tank”) will front the founders a large sum of money in exchange for an ownership stake in the business. Once the business reaches a certain valuation, it can go public and the initial investors can sell their shares for a tidy profit.
While IPOs are often used to let initial investors sell their shares, businesses may also go public to:
- Raise additional capital to fund expansion, pay off debt, or develop new products
- Garner publicity
- Make the business more appealing to lenders
Going public can make it far easier for a business to raise capital. But IPOs also make managing the business far more complex, due to SEC filing requirements.
What Is an IPO? Key Terms You Need to Know
Initial public offerings, like everything else in the wide world of investing, have their own language. Fortunately, there is plenty of overlap between IPO jargon and other investing terminology. However, you may come across a few unique terms when researching IPOs, including:
- Common Stock: Standard shares of a company that go for sale on a stock market during an IPO
- Issue Price: The amount that investors will pay for stock before an IPO company lists its shares on public exchanges
- Lot Size: The fewest number of shares you can place a bid on during an initial public offering
- Preliminary Prospectus: A document created by a company prior to going public that discloses details about its finances, strategy, and operations
- Price Band: The range that investors can bid for shares; each type of investor has their own price band
- Underwriter: The advisor/investment bank that assists an IPO company with going public
When making bids on IPOs, pay particular attention to lot size and issue price. For instance, if the issue price is $1 per share and the lot size is 100 shares, you can bid no more than $100 for a lot of shares.
In 2021, dozens of companies went public, providing investors with plenty of options for expanding their portfolios. Now, fewer companies are going public due to a variety of economic factors, including rising interest rates and high inflation. Still, several promising businesses have announced plans to go public or are expected to do so by year’s end, including:
- Surf Air Mobility
- Impossible Foods
While it is unclear which of these businesses will actually follow through, you should keep a close eye on them if you are interested in purchasing IPO shares.
How to Buy IPOs
Once a stock goes public, buying a share is as easy as launching your favorite trading app, selecting the number of shares you want to purchase, and hitting “Submit.” However, if you want to purchase IPO shares at the issue price, you’ll need to connect with a brokerage that facilitates these types of orders.
Keep in mind that not every broker offers access to IPOs. Some that do include E*TRADE, TD Ameritrade, Charles Schwab, and Fidelity. That said, even after you connect with the right brokerage, you will have to meet eligibility requirements.
For instance, you may have to maintain a minimum account value. Alternatively, they may require that you have conducted a specific number of transactions within a particular time frame (e.g., 10 transactions in the last 12 months).
Should You Invest in IPOs?
IPOs can be more risky than other types of investments, such as shares in established public companies. There are many unknowns associated with IPOs, which makes your decision even more complicated.
However, IPOs can be a good tool for diversifying your portfolio. As always, only invest what you can stand to lose, and don’t overcommit to a single stock, no matter how confident you are in a company.
Learn More About IPOs and Other Investment Opportunities
Knowledge is power, especially when it comes to investing in the stock market. The more you know, the better your odds of turning a profit and achieving your financial goals. But let’s face it, you don’t have time to spend hours of your week doing research and watching the ebbs and flows of the stock market.
The good news is that you don’t have to. At Gorilla Trades, we do the legwork for you and send insights straight to your inbox. We also publish informative content about investing topics, like IPOs, bonds, and more. Sign up for a 30-day free trial to put our stock recommendations to work for your portfolio.