An initial public offering (IPO), or “going public,” is when a private company begins selling stock to public investors. Though risky for beginners, buying an IPO stock can be exciting, as you could have the chance to “get in on the ground floor” before a potentially great stock starts making extraordinary leaps.
How exactly does an IPO work, what are the steps to buying one, and should you take the plunge? Let’s take a closer look at IPO stocks and see.
What are IPO stocks?
An initial public offering (IPO) is simply the first time the public can trade a company’s shares on a stock exchange. Before an IPO happens, companies are privately held by a small group of shareholders, such as the company’s founders, its employees, and venture capitalists. Once the company goes public, it allows outside investors to own a slice of the company, allowing them to profit when share prices go up, as well as make certain decisions, such as who makes up the board of directors.
Companies go public to raise more funding for its own development. Typically, a company will reinvest shareholders’ money in product research and development, helping the company grow bigger in the long-run.
How does an IPO work?
When a company wants to transition from private to public, they first hire an investment bank to help them initiate the IPO process. These banks act as intermediaries between the company and the stock market, helping the former understand the value of their stock, as well as issuing shares to investors when the time is right.
Investment banks will start a process called underwriting, during which the bank helps companies determine how much money they need to raise, what type of securities they will sell, and the various fees the company will pay to the bank. The bank will also help the company tighten up its financials, which will help make the company become more profitable in the long run, possibly raising its initial share price.
Once both parties come to an agreement, the bank will package its work into a “registration statement” and file an IPO with provincial regulators. Unlike other countries, like the United States, Canada doesn’t have a national regulator. Instead, each province’s regulators will look over the bank’s registration statement, checking to be sure all pertinent information has been revealed. If the provincial regulators approve the statement, they’ll set an IPO date when the public can start trading shares.
Typically, the IPO date is several months out from the time of approval, sometimes longer. During this time, the company and its investment bank will enter a “marketing phase,” so called because the company will try to generate as much hype around its stock as possible. The bank will also issue an initial prospectus, which reveals to the public the company’s finances, along with other important information that will help investors decide if the company is worth investing in.
At last, as the IPO date approaches, the company and the bank will decide on an initial share price. This is perhaps the most important part of the IPO process: based on the company’s finances, as well as the hype generated during the marketing phase, not to mention market conditions at the time, both parties will price the stock as reasonably as possible. The company wants to raise funding from the IPO, but they also don’t want to overprice the stock and fail to attract investors.
When the IPO date arrives, investors can buy stock on an exchange — and the game begins.
How can you buy IPO stock?
We hate to break it to you, but not everyone can buy IPO stock. In order to get your hands on this type of stock before it hits the market, you’ll have to jump through a number of hoops. If you’re interested, here’s what you should expect to do:
1. Use a broker who has IPO stock
Not every broker will have access to IPO stock. Investment banks typically divide shares and allocate them to different brokerages, leaving some out. If you’re working with one of the best brokerages in Canada, you might have access to these shares, but it’s worthwhile to double-check before you sign up whether a brokerage has sold IPO stock in the past.
2. Demonstrate eligibility
Now, just because your broker sells IPO stocks doesn’t mean they’ll sell it to you. Often, each brokerage has certain requirements you must meet in order to buy IPO stock. For instance, they may require you to have a certain amount of money in assets, or they may look at how many times you’ve traded in the last year.
3. Request shares
If you do meet requirements, and your brokerage allows you to buy IPO stock, then congrats — now you get to decide how many shares you actually want to buy.
At this point everything is still hypothetical: though you may request, say, 100 shares, your brokerage may only give you five. Typically, at this point, you won’t know the price, either. So you may request 100, then lower your shares when you find out how much they cost.
4. Place your order
Finally, the big day arrives: the investment bank and company have decided on a share price. Your broker will contact you immediately, letting you know how much each share will cost, as well as give you a deadline to place your order. Usually, you still won’t know how many shares you’ll receive (if any at all). But, at least you can be certain how much you’ll pay per share, as well as the maximum number you could receive.
What are the pros to buying IPO stocks?
Perhaps the biggest benefit to buying an IPO stock is the potential to get extraordinary gains with a stock’s long-term growth. If you buy a stock at its initial price, you can potentially maximize returns, so long as the stock doesn’t fall below its IPO price.
Consider Shopify, for instance. When Shopify went public in 2015, its shares sold at a mere $17 a pop. If you had bought 588 shares of Shopify back then (roughly $10,000), you’d be a millionaire today.
What are the cons?
But not every IPO becomes a Shopify. For every success story, there are dozens, if not hundreds, of failures. In fact, if the biggest advantage to IPO stocks is extraordinary gains, the biggest disadvantage is the opposite — buying an IPO stock that eventually flops. Investors can lose a lot of money if a company’s stock never rises above its IPO price (Lyft and Uber are the first to come to mind).
For that reason, investors should approach IPO stocks with a long-term perspective. Canadian who are nearing retirement have no business playing around with IPOs, as they can take years, sometimes decades, to reach a place where investors are making money.
Should you invest in IPOs?
For beginning investors, however, IPO stock investing can be difficult, if not downright risky. For one, you’ll need to meet your broker’s requirements to buy IPO stock, having the appropriate amount of money in assets or the required trading experience. Even if you meet the requirements you’ll still need to dig deep into a company (its competitive advantages, management, and size of its market sector) before you decide to buy its stock.
For those just starting out, you might want to get some more investing experience before you play with IPOs. Because companies and investment banks build tons of hype around a stock, it can be easy to get sucked into a bad investment. In addition, IPO stocks tend to underperform the market in the short-term, while others will become long-term losers.
While we don’t want to discourage you from buying an IPO stock in a company you believe in, we do encourage you to be careful — there are plenty of high-quality stocks you can buy right now. If you keep a long-term perspective, you can build incredible wealth on stocks young and old, without requiring you to “get in early” on a hot deal.