The Attractiveness of IPOs, Part I

by Dual Income No Kids on October 13, 2009 · 0 comments

Investing is a constant battle between risk and reward. All investments lie on a spectrum ranging from the safest investments to those which can best be described as gambling; if you’re willing to accept a higher degree of risk, you are usually putting yourself in a place to potentially collect a higher reward. Of course, riskier investment tend to be quite volatile, and the probability of success is greatly diminished. As such, all investments should be approached with a clear understanding of the risk involved, and every investor should constantly be evaluating their personal risk tolerance level. With that being the case, a very attractive investment is the IPO, as it presents the investor with a high level of risk, but the payoff can be quite lucrative.

What are IPOs?

An Initial Public Offering (IPO) is when a company issues, for the first time, common shares of stock in their company to the public (referred to as “going public”). Obviously, this is a pivotal moment in the financial evolution of a company, and can be motivated by a variety of reasons. Likewise, for an investor, it presents an opportunity for a high level of growth, both in the short term and in the long term. Contrary to what some may tell you though, an getting in on an IPO is necessarily a golden ticket, and it can, in fact be disastrous in the wrong situation. Additionally, there are issues associated with investing in an IPO that could render this whole conversation moot, or at least diminish an IPO’s attractiveness.
Why Do Companies do IPOs?

Most commonly a company will issue an IPO for two reasons: either they are a small, young, rapidly growing corporation looking to raise funds to facilitate further growth, or they are an older, more established firm looking to leverage the power of being publicly traded.
Small, young companies obviously face a lot of challenges. The market is usually saturated with larger, more established corporations who maintain control of the customer base. Growth can be difficult, and even with support from private investors, money can be tight. One way these issues can be mitigated would be to go public; qualifying for and then issuing an IPO will raise a lot of money (potentially) very quickly for the company. These companies can maintain control of their organization while raising the funds necessarily to improve their position in the marketplace and better take on the older, more established firms in their market segment.
For older companies who are more established but remain privately owned, issuing an IPO offers more benefits than just raising capital (although that is also a common motivator). When a company goes public, they have to open their books up to stronger scrutiny. While this at first glance may appear to potentially be a bad thing, it also has its benefits. For one, if that company needs to borrow a lot of money, they can often get good rates on their loans, as the loan underwriters can better evaluate the solvency of a company. Additionally, mergers and acquisitions can also become easier, as shares in the company can be exchanged as part of the financial agreement.
But just because a company wants to go public doesn’t mean that they automatically qualify. Initiating an IPO is a long and arduous process, involving a series of banking underwriters, securities lawyers and the Securities and Exchange Commission (SEC). There are a multitude of issuance flavors (self distribution, all-or-none contract, dutch auctions, etc…) and secondary procedures involving the listing type, secondary offerings, etc… But be that as it may, the ultimate goal is to raise as much cash as possible in a short amount of time.
How Can You Make Money with IPOs?

IPOs can be great, because they allow an investor to get in on the “ground floor” of a security, which can yield great profits. For example, Google debuted at $85 a share back in 2004; five years later a single share in Google will cost you over $500. Additionally, IPOs are historically underpriced at their initial offering price, opening the door up for “flipping”, the process of buying into an IPO and then selling a short time after, when the stock prices shoots up, resulting in a huge profit in a short period of time. While great for the investor who does this, flipping is bad for the company, as the price difference between the offering price and the institutional value is viewed as “money left on the table”, short-changing the company vast amounts of capital that it was hoping to raise. Underpricing is done usually to avoid overpricing; when the initial offering price is too high, and the bank underwriters face difficulty in selling the number of shares that they are obligated to as part of their agreement with the company issuing the IPO. Additionally, the volatility of the initial share price can lead to institutional instability, as seen in the early 2000s, when .com startup owners sold larger numbers of stock that they held in their companies in an attempt to cash in on inflated share prices, leading to a cash crisis which often in turn lead to insolvency and financial ruin.

The Risks of IPOs?

Despite those issues, one might think that an IPO might be worth the risk, and one might be interested in getting involved. Unfortunately, it’s not as easy as calling up your local Charles Swab agent and placing an order. Most initial investors are institutional, and it can be very hard for an individual to get in on the action (and by very hard, I mean practically impossible for the average investor). Instead, IPOs should be treated as any other investment. Do your homework, determine if the company has a future, and if so, buy in – when you can, which will certainly be at a price higher than the issue price – and hold on through the inevitable volatility that comes in the first year after an initial offering. There are money making opportunities with this investment, like any other, but you have to have the proper knowledge. Although as an individual it is highly unlikely that you’ll ever have the opportunity to get in on the issue price, getting in early on a successful company can be a boon on any investment account.
In my next post I will discuss some of the most successful and unsuccessful IPOs in US history.
-Michael
Twitter: @michael_dink

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