What is an IPO, and how can you invest?

When a company wants to go from being privately owned to being publicly traded on a stock exchange, it typically holds an initial public offering (IPO). But these events are reserved for large investors with big portfolios, and usually smaller investors have to wait until the stocks move to the exchange.

What is an IPO?

An IPO is the event in which a company offers investors the chance to invest in the company for the first time. This happens when a private company decides to go public and list on an exchange.

For example, if a private US-based company decides to list publicly on the New York Stock Exchange (NYSE), it’d hold an IPO to offer shares in their company to investors. IPOs are sometimes called a float, and often create a lot of hype and excitement, particularly if it’s a well-known brand.

Can anyone take part in an IPO?

It’s difficult for individual –– or retail –– investors to take part in an IPO, particularly if it’s a well-known company. Because the company only has a limited amount of stock to offer, the shares available through IPOs are often reserved for:

• Large institutional investors. These include other businesses, investment banks and similar institutions.
• High-net worth investors. Typically those with large portfolios and annual income over a few hundred thousand dollars.

Retail investors might get access to an IPO if the demand for the IPO has been lower than expected. You’ll need to be signed up with an online broker to get invited to take part in the IPO.

If your broker is offered a portion of the company’s shares to sell to clients, they send out the application form for you to complete. Usually, you’ll need to commit to buying over a certain amount of shares, and you’ll be given a tight time frame to submit your application to take part in the IPO.

However, if you can’t access shares via the IPO it doesn’t mean you can’t invest in the company. When the IPO is over and the shares are officially trading on a public exchange, anyone with a trading account can buy the shares.

Why do companies hold an IPO?

The main reason a private company holds an IPO is to raise money. A few reasons companies raise money include:

If the company needs to raise money but doesn’t want to list on a public exchange, they’d need to source some private funding. Private funding can come from other companies and investment managers, or high-net worth individuals directly. However, companies often choose to hold IPOs in order to to maintain control of their company, something they may have to give up if they resort to private funding.

How are IPO share prices set?

When a company decides to list its shares publicly on an exchange via an IPO, a lot of work goes on behind the scenes to determine a fair price for the shares.

IPO share price is determined by:

When a company decides to go public, it hires an investment bank to help it achieve this via an IPO. This investment bank is known as the underwriter of the IPO.

The underwriter helps determine how to price shares. IPOs offer a predetermined number of shares to investors at a set price per share — rather than changing throughout the day like shares on the NYSE.

IPO share prices are not always accurate

There’s no guarantee that the share price offered through an IPO represents fair value for that company’s shares. Some IPOs for popular brands create excitement, but this doesn’t mean it’s a good investment.

Sometimes, if the share price doesn’t represent the company’s value, the price falls immediately after the company is listed on the exchange. This gives retail investors a chance to get the same shares for a lower price on the exchange.

However, sometimes the market hype drives the prices to rise after the company’s IPO — making it a good investment, unless the hype lifts the price to an overpriced level. Then it can drop in the weeks and months ahead.

Are IPOs and SPACs the same thing?

You can think of a special purpose acquisition company (SPAC) as another vehicle in which a private company can reach the public market. A SPAC is a company that goes public in order to raise money to acquire another company within two years. So the SPAC goes public first, acquires the private company and then gives it a public listing. As a result, the private company bypasses the traditional IPO process, which can be costly and complex.

Taking the SPAC route to the public market is becoming an increasingly popular alternative to the traditional IPO process because it tends to involve less paperwork and government oversight. And investors are jumping in too. Throughout 2020, SPACs have raised a record $31 billion.

SPACs are typically formed and managed by experienced executives. They tend to seek money from institutional investors, private equity funds and high-net worth individuals. Also known as blank-check companies, SPACs don’t disclose the companies they are targeting, so investors to the SPAC don’t really know what they may be investing in.

Are IPOs and ICOs the same thing?

No. ICOs are held in the cryptocurrency world, while IPOs involve traditional private companies. The difference between IPOs and ICOs can be summarized in four key points:

1. How funds are raised
2. Investment instruments involved
3. Company ownership
4. Risk involved

To learn more about the similarities and differences of these fundraising methods, read our complete breakdown on the differences between ICOs and IPOs.

Should you invest in an IPO?

If you have an opportunity to buy shares via an IPO, understand the benefits and risks involved.

Benefits of investing in an IPO

• Fixed share price. Unlike regular shares, IPOs offer a fixed price per share that won’t change until the IPO is over. This time gives investors a change to researching the investment opportunity.
• Get in early. Investing in an IPO gives you the opportunity to be among the first to buy shares in a company, before it’s listed on the exchange.
• Invest in popular brands. IPOs give you the chance to invest in brands new to public trading.
• Potentially sell your shares for profit. Well-known brands can see share price rise significantly once they’re listed on a public exchange. If your share increases after the IPO, you could sell them at a profit. Thought this is a high-risk strategy — and past performance is no guarantee of the future.

Risks of investing in an IPO

• The share price could be overvalued. The set share price offered through an IPO might not be fair value, and you could end up paying more for the shares than they’re worth. If the market thinks the shares are worth less than they’re priced, the share price will fall after the company goes public meaning you could lose money to begin with.
• New companies are often high risk. Many IPOs are held by newer companies that have only been operating for a few years. Because they’re often still in their growth phase, they’re likely to be higher-risk and more volatile than other shares. However, they also offer the potential for strong capital growth.

Compare platforms to buy stocks

If you’re not able to invest in an IPO before it hits the market, you can wait until the stock is publicly traded and then invest by buying the stock. Keep in mind, early trading of new shares can be volatile.
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Bottom line

Companies hold IPOs when they’re ready to sell their shares and go public. Most large institutes or high-dollar investors invest in IPO — low-dollar retail investors are generally kept out.

When the IPO is over and the shares are publicly listed on the market, anyone can buy them. Find out when the shares are available on the exchange and do your research to determine how much you’re willing to pay. Then compare stock trading platforms, that way you’ll be prepared when the stocks finally hit an exchange.