They say the earlier you get into an investment, the better your returns will be. This is the allure of the IPO: investing in a burgeoning company as early as possible to capture exponential gains. Too bad not all IPOs perform well. In fact, these investments might be riskier than investors realize. So, are IPOs the sound investment everyone thinks? Or are they simply risky investments dressed up for investors to fight over?
When a company begins to grow it has a few options for accessing the capital it needs to continue its business operations. One way to do this might be to issue corporate bonds, using debt to gain access to capital immediately, and paying borrowers back with interest payments. However, another way to access funds would be to break the company down into shares of stock and sell off a portion of those shares to investors.
This method is known as an initial public offering (IPO). In an IPO, investors who purchase shares of the newly created stock own a proportional amount of equity in that stock’s underlying company. If you purchase 1 share of Amazon stock, you own 1 share worth of Amazon the company (which, as you might have guessed, is miniscule). By selling equity in the company, capital can be raised to grow the underlying business even further.
IPOs are also a great way to provide returns to early investors like venture capitalists and angel investors. When a company issues shares via an IPO, these early investors receive shares equivalent to their early investment in the company, which they can then sell on the open market once the company goes public.
Catch on the Train
For investors who can get in on the ground floor of an IPO, it can mean huge returns. That’s because at the time a company is issuing its IPO has garnered significant attention for their growth and profitability over time.
Streaming television company Roku went for its IPO in 2017, listing at $14 per share. Two years later and the stock price has skyrocketed north of $65 (at the time of publishing) and shows no signs of slowing down. Twitter came out at an IPO price of $26, and although the company has had its fair share of ups and downs, it currently trades above $40 per share (at the time of publishing). Facebook is another social media IPO success story, with shares offered at $38 now worth almost $200 (at the time of publishing).
Needless to say, there are a slew of IPO success stories that have kept investors coming back. But, with every successful IPO, there are many which end up faltering along the way, producing significant losses for investors.
Don’t Always Buy into the Hype
While IPOs are often a great investment, they also can bring significant hype, which leads to mispriced offerings. Big-name companies have seen their stocks falter immediately following an IPO which was later deemed to be overpriced by the company and its underwriters.
There have been some historically bad IPOs which have lost investors millions of dollars. Many of these historic misses came from overhyped tech companies which were believed to have higher valuations than their underlying businesses.
- Pets.com raised $82.5 million in its IPO right before the dot-com crash and was out of business less than one year later
- Social media company theGlobe.com saw its IPO jump over 600% in 1994 during its first day of trading, the largest such jump in history. Yet, the company didn’t last long and was out of business by 2007.
- Internet-based logistics company Webvan.com was a pioneer in the grocery delivery business, but may have been ahead of its time. The company was able to raise $375 million in 1999, by was out of business just two years later. The company’s claim that it could deliver groceries in 30-minutes or less was more fiction than fact.
There are other instances of companies going public which aren’t historically bad, but with valuations which are severely inflated as compared to the actual value of the underlying business. Snapchat rose 44% in its first day of trading in 2017 after an IPO which valued the company at about $33 billion. However, it’s been rough going for the company since then, and the stock currently trades at less than 50% of its $24 IPO price.
The truth is, even though they can be some of the most exciting investments, statistically IPOs underperform the market considerably. In fact, according to one study, IPOs return only 5% in the first five years, compared to 12% for companies of a similar size.
Returns Might Take Time
Investors are always in search of the quickest way to make money. IPOs, while potentially lucrative, may also require holding for many years before returns really pay off. That’s because companies which IPO are generally not at full maturity and are still growing.
Take Apple as an example. The company released its IPO in 1980 for a price of $22 per share. The stock ebbed and flowed for several years, not doing much by way of returns. Then, in 1987, Apple began to takeoff, and the company split its stock, providing the first wave of positive returns for investors.
However, the next decade was one of questionable returns, and it wasn’t until the turn of the millennium that Apple came into its own. Yet, the dot-com bubble and subsequent market crash hurt the company’s stock significantly.
There was another five years of the company’s stock price stalling before Apple became the company we know today. As a result, its stock price, began to climb exponentially. Over the past 15-years, Apple has been one of the best-performing stocks on the market. As a result, if you held on to Apple stock since its IPO, it would have generated you over 50,000% in returns. That makes a $100 investment in Apple’s IPO worth over $50,000 today!
As you can see, investing in an IPO can generate significant returns for investors, but such returns may take some time to develop.
Upcoming IPOs to Watch
In the IPO world, tech companies still rule the headlines. Ride-sharing company Lyft recently had its IPO, while rival Uber could raise the biggest IPO in the past decade this week. Airbnb is rumored to be gearing up for its own IPO later this year, but there is also a chance that the move won’t come until 2020. Asana, the project management app, recently was valued at $1.5 billion and could have an IPO of its own, although the company is declining to comment on such rumors.
One of the most-watched companies expected to IPO this year was Slack. Instead of a traditional IPO, the company decided to go with a direct listing offering, where no funds are raised for the company, and instead, existing shares are sold. While this is a much cheaper method of going public, it also doesn’t raise any capital for the company, which could come back to bite it later down the line.
All of these IPOs are companies which have high expectations and significant weight behind them. Still, don’t expect guaranteed positive returns from these upcoming listings, and as always, make sure to do your own due diligence before investing.
How to Invest in an IPO
Unlike investing in the stock market after a company has gone public, investing directly in an IPO can be difficult, especially if it is for shares which investors are fighting to get their hands on.
IPOs are generally only offered by certain brokerage firms with access to the shares. Additionally, these brokerages can put restrictions on who can invest in the offering, and a minimum investment amount, as IPOs are deemed as extremely volatile and risky. For instance, TD Ameritrade offers IPO investing, but only to those who have at least $250,000 in a brokerage account and have complied with FINRA by completing the IPO Eligibility Form. Other firms, like Fidelity, require a certain amount of household assets and a purchase of at least 100 shares of the IPO.
IPO investing, while extremely risky, can be equally as lucrative. Just do yourself a favor and understand all of the risks involved in IPO investing before jumping in head first.
Disclaimer: The information in the post is for educational purposes only, and should not be taken as investment advice. Please consult an investment professional before making any financial decisions.