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What is an IPO, and how can you invest?

A company holds this event when it's ready to sell to investors.

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

What is an IPO?

An IPO is the event where 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 SA-based company decides to list publicly on the Johannesburg Stock Exchange (JSE) 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 netting more than a million rands.

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 share 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:

  • Help the business expand into different markets.
  • Launch new products.
  • Hire more staff.
  • Take the business overseas.
  • Invest in new infrastructure or technology systems.

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:

  • The company’s current value.
  • Potential future earnings of the company.
  • Number of shares offered.

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 JSE.

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.

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

Should you invest in an IPO?

It’s difficult for individual investors with small portfolios to take part in an IPO. If you’re a high-net-worth investor or 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 chance to research 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.

Bottom line

Companies hold IPOs when they’re ready to sell their shares and go public. Most large institutes or high-income investors invest in IPO — lower-income 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.

Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.

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