Initial Public Offerings – Should You?

Initial public offerings (”IPOs”) is a term that describes the first time a formerly privately held company issues shares of common stock for sale to the investing public. An IPO provides the company with an influx of cash and the investors the opportunity to “get in on the ground floor” of the newly publicly traded enterprise.

But are IPO’s suitable investments for everyone?

In the 1990’s the market for IPOs was extremely strong and popular. There was significant demand among investors to acquire shares of stock for companies, such as tech companies, that were expected to appreciate greatly in a short period of time. And they were right. Many portfolios were significantly enlarged by the numerous profitable IPOs that came to market into the 2000’s.

However, the credit crunch and Great Recession of the late 2000’s burst the IPO market bubble.

Today, the IPO market has recovered. But the recent history of IPOs offers a cautionary tale to investors (at least it should). While there can be significant upside potential in IPOs there is also significant risk.

In an IPO, shares of the newly public company are allocated among the firms that were part of the underwriting syndicate that brought the company public. The firms then allocate the shares they received to individual brokers for sale to the firms’ customers. The shares of IPO are typically offered to select customers. Mutual funds, money managers and investment advisors often receive the lion’s share of IPOs. What’s leftover typically goes to other large individual investors or clients who are active traders that generate significant commissions and fees for their broker.

Moreover, while the firm’s top clients receive the bulk of shares allocated to the the firm, those clients will often sell their shares if the offering price appreciates immediately in the secondary market. Indeed, there are instances where the firms that are members of the offering syndicate will attempt to artificially support the price of the new offering to insure that the firms’ top clients who receive allocations of the IPO can sell their shares at a profit once the price goes up in the secondary market.

However, if the price of the IPO has been artificially supported, once that support is withdrawn, the share price of the now publicly traded company can drop resulting in losses to those unlucky investors who either held onto the IPO or purchased shares in the secondary market.

If you are not one of the favored clients, shares of a popular IPO may not be made available to you (which leads to the question, if you are not one of those favored clients, and IPO shares are available, does it tell you something that institutional investors and other large clients have passed on the IPO; maybe it's not such a good investment?).

If you do determine to invest in an IPO, there are some prudent steps you can and should take. While, as stated previously, the formerly privately held company has no prior stock performance history, you can look at the performance of publicly traded companies that are competitors in the same industry or business sector.

You should also study the prospectus. Under SEC regulations firms are required to make detailed disclosures about the company in the prospectus. You can learn who the companies’ officers are, how much debt the company carries, who the companies competitors are, who the companies’ best customers or clients are.

One piece of information you should ascertain prior to participating in an IPO is the answer to a very basic question: what is the company going to use the money raised in the IPO for?

Are they intending to expand their operations by acquiring new facilities, buying a competitor, increasing the size of the workforce or research and development? All potentially good signs that company’s business will move forward.

Conversely, is the company purchasing private equity stakes from the companies’ founders? Does the company plan on retiring debt and not increasing business capacity?

Maybe not such good signs.

For many investors, the only way to participate in an IPO will be to buy shares after the IPO closes and the stock is trading in the secondary market. However, if there was a jump in price immediately after the shares were offered, will the sale of shares by investors who were able to buy in the IPO cause the price to fall?

All of the above points to the fact that investors should consider participating in an IPO as a speculative investment.

If you have questions about an IPO in which you participated, or the handling of your brokerage account, contact the experienced securities lawyers at Lubiner, Schmidt & Palumbo for a consultation.