Initial public offerings (IPOs) are milestones in the stock market calendar. An IPO is where a company gives the public an opportunity to buy shares in the company for the first time. This article will introduce you to initial public offerings and explain how to invest in an IPO.
Also, we will highlight some common pitfalls for IPO investors.
What is an IPO?
An IPO is the initial issuance of shares to the public, who ‘subscribe’ to the sale weeks in advance.
It is a necessary step which enables a private company to become a listed public company with a quoted share price and thousands of shareholders.
In an IPO, a company either:
- Offers new shares to the public, raising new funds to help the company expand. Therefore after the listing, the company will have more assets and more shareholders; or
- Allows existing shareholders to sell their stakes to the public. The funds from these sales go directly to the original owners of the shares. The company itself does not receive any financing and therefore remains the same size.
Once the initial offering or ‘primary sale’ occurs, the IPO subscribers can immediately sell these on the stock market just like any other listed shares.
Why do companies want to become listed?
1. They need to raise funds
As a company grows, it will usually need more money to fund their expansion, for example hiring new employees and purchasing equipment.
Companies have four main fundraising routes:
- Obtaining a loan from a bank
- Borrowing from the debt markets by issuing corporate bonds to investors
- Inviting private investors to contribute funds and receive some new shares
- Raise funds via an initial public offering of new shares on a stock exchange
Selling shares is preferable for larger companies which have already taken on an optimal level of debt. Debt is a useful way for companies to increase their return to shareholders, but the share price will begin to suffer if the debt burden becomes significant.
2. Public companies obtain cheaper funding than their private counterparts
As we explained in the Science of Diversification, investors demand a higher return from a riskier investment. In practice, this means they are prepared to pay a higher price now to receive a stream of dividends in the future if they will be exposed to less risk.
Quoted shares are less risky than their private counterparts. This is because:
- Quoted shares are liquid – an investor can sell their shareholdings on the same day.
- Executive managers tend to exercise better oversight over public companies. This is because regulations force them to comply with more stringent corporate governance requirements. This increases the focus on identifying business risks and monitoring conflicts of interest on the Board of Directors.
- Public companies have higher quality financial reporting. Regulations require them to develop robust internal controls to detect fraud and error. External and Internal audits subject the financial statements to a rigorous series of checks, which increases the trust that shareholders place on them.
As a result of this reduced risk, a public company is able to raise funds by selling fewer shares at a higher price per share, compared to an identical private company.
2. Listing creates an exit opportunity
A common motivation to go public is to provide an easy way for founders and early investors to sell their shareholdings at the best price.
It usually takes five years or more for a company to meet all the conditions for a successful IPO. By this point, many different shareholders will sit on the shareholder register. Some of these parties will be eager to find a way to convert their successful investment into cash.
Early investors could include:
- The founders
- Seed or angel investors (early-stage investors which help start-ups get off the ground)
- Venture capital funds (later stage investors which can provide large cash injections while a start-up is loss-making).
- Employees who have received shares
- Banks which may have converted their loans into shares
How does an IPO work?
Step 1: Building a team
The company brings several external experts on board. This is usually a selection of investment banks and an audit firm. Because IPOs are such rare events, a company will never have the expertise in-house to go it alone.
In addition, Investment banks offer a service called ‘underwriting’. This is where, for a fee, they promise to step in and purchase any remaining unsold shares if there is insufficient demand on the day of the IPO.
Step 2: Creating a Prospectus
With the assistance of the investment bank, the company produces a ‘Prospectus’. This document is subject to many rules and requirements. It provides insights into the operations, strategy and future plans of the company.
The prospectus includes three years of audited historical financial information. This allows potential investors to gain a broad understanding of the business to help them decide whether they want to invest, and at what price.
If you’d like to see an example of an IPO prospectus, check out Aston Martin’s prospectus from 2018.
Step 3: Setting a price
Through dialogue with potential investors together with their own analyst research, the investment banks help the company decide on a fixed price or a price range for their shares.
Setting the right IPO price is crucial. A company won’t sell its shares if the market believes they are overpriced. Any subscriber that pays a premium over the true value will suffer an immediate loss when the shares begin trading at their lower, fairer value in secondary trading when markets open the following day.
Therefore, companies deliberately underprice their IPO to ensure their success. Sometimes the discount is as high as 25%. An underpriced share is likely to ‘pop’ or rise on the first trading day as it aligns with its fair value. This price surge is a gift to all IPO subscribers. The prospect of a large ‘pop’ in the share price on day one drivers much of the excitement around IPOs.
Step 4: Creating demand
Behind the scenes and in the press, the investment banks use their network of contacts to drum up interest in the company ahead of the IPO date. The hype machine enters into full swing, while financial journalists begin speculating about whether the IPO will be oversubscribed.
If the bankers have chosen an appropriate price point, investors should not need too much convincing. However, if the stock market conditions become gloomy, or some negative press emerges during the IPO process, it can become a real struggle to keep the market consensus within the original price range announced.
Stockbrokers will contact their clients in the period leading up to the IPO, to offer them the opportunity to participate. Some stockbrokers email their client base about upcoming IPOs, but others will simply list them on the IPO section of their website. Beyond a stockbroker trading fee, no other fees are charged for an IPO.
Step 5: Going Public
The IPO itself – the primary sale – occurs the evening before the stock market allows secondary trading in the shares. An IPO that is successfully marketed, will be heavily oversubscribed. With too few shares to satisfy demand, shares are allocated to subscribers using one of two allocation methods. Which method is used will depend on how the final IPO price was decided.
- Fixed price – Shares are allocated across all subscribers proportionately to the order size.
- Price range – The book building method sees shares allocated first to the subscribers who placed orders at the top-end of the price range.
Depending on the allocation method, investors either have an incentive to over-order, or increase their subscription price, if they want to increase their chances of receiving the desired number of shares.
Recent IPO examples
We have compiled the following table to show the first-day share price performance of some recent high profile IPOs, compared to their IPO price.
|Company||Date||IPO Price||Day One Closing Price||Gain / (loss)|
|Uber Technologies||10 May 2019||$45||$41.57||(7.6%)|
|Lyft||29 March 2019||$72||$78.29||8.7%|
|Fiverr||12 June 2019||$21||$39.90||90%|
|Avantor||16 May 2019||$14||$14.50||3.6%|
|Aston Martin||2 October 2018||£19||£18.1||(4.7%)|
|Beyond Meat||2 May 2019||$25||$65.75||163%|
As you can see, some IPOs have delivered monumental returns on their first day. It also shows that some IPOs are ‘duds’, and lose their subscribers money. It isn’t necessarily rosier when we zoom out; the shares of Aston Martin lost 75% of their value in the year following its IPO.
Is investing in all IPOs a winning strategy?
One method to take advantage of IPO pops would be to invest £1,000 in each IPO opportunity and sell the shares one day later to realize any profits.
Unfortunately, this idea might not work in practise – even if it was used on the IPOs in the table above.
How could this be? Well, the missing link you need to appreciate is the issue of supply and demand.
When an upcoming IPO is widely understood to be deeply underpriced, it can become oversubscribed hundreds of times over. This shouldn’t surprise anyone – free lunches are very rare in the world of investing! Many investors who hear about it will also want to take part. This will include professional investors and wealthy private investors with millions of pounds at their disposal.
With so much money chasing a relatively small number of shares, small investors get crowded out during the allocation process. Of your £1,000 subscription order, you may only receive £20 of shares!
Conversely, when an IPO has a lukewarm reception, its IPO might be undersubscribed. In these cases, your order will be fully allocated. The lack of enthusiasm in the IPO will bode poorly for the performance of the shares on their first day of trading.
You will feel the effect of being crowded out of the best opportunities, and left to saddle the full weight of underperforming IPOs. Therefore, this means that returns from this basic strategy are likely to be poor.
A more sensible approach
It logically follows that you should be selective when investing in IPOs. If a deeply discounted opportunity comes along, your stockbroker may give you the chance to participate.
However, to avoid disappointment at being ‘allocated’ down, you may need to use additional cash to ‘over-subscribe’ to the IPO. However, this strategy carries some risk. Because in the event of the IPO being unexpectedly unpopular, you may be left with a significant holding of unpopular shares!
Some opportunities remain
A notable exception to the trend of small investors being ‘crowded out’ was the listing of Royal Mail in the UK in 2016. The government-led allocation process protected small investors by giving their requests priority over any orders over £10,000. This allowed 350,000 small investors to make a £300 profit from the 44% pop in the share price on the first day of trading.
What is an IPO and How to Invest in one
An Initial Public Offering (IPO) is where a company sells some shares directly to the public. This is know as the primary sale.
The day after the primary trade, the shares can be traded with other investors on a designated stock exchange. This is known as secondary trading.
A company may choose to become public to sell new shares to raise money to fund an expansion. Alternatively it may become public to allow existing shareholders to sell their stakes.
Public companies are subjected to more regulation and scrutiny. However for this reason, and increased liquidity, public companies are less risky investments. Therefore a public company can raise more cash whilst giving away fewer shares.
Companies enlist a group of investment banks and an auditor to assist them in preparing a prospectus document for investors. This will include three years of audited financial performance data.
Your stockbroker will feature a list of upcoming IPOs on their website. You can register your interest online, and await further instructions on how to place an order for the IPO.
The company sets a fixed price or a price range for their listing. They tend to underprice the shares to ensure high demand for the sale.
If demand exceeds the number of shares available, shares will be allocated in a fair way. If the IPO has a fixed price, this will be proportionate to the size of orders. Where a price range is given, priority will be given to the highest priced orders first.
A discounted IPO usually results in a 'pop' or sharp rise in the price of shares when they begin secondary trading on the stock exchange. This means that original subscribers to the IPO may enjoy a quick profit.
However, some IPOs fail to attract enough buyers, either due to poor market conditions or premium pricing. Investors who subscribe to these IPOs may suffer a loss on the first day of secondary trading instead.
- If you'd like to invest in an IPO, search online for 'upcoming IPOs in [your country] in [your year]' to size up any opportunities in the near future.
- Research recent IPOs and understand whether their prices 'popped' on day one, and how the share price has performed since. Search for news and opinion pieces which were published before the IPO. With the benefit of hindsight, compare whether the reality of the IPO matched their written predictions. If accurate, make a note of the source and be sure to check back when the same source writers about an IPO you are interested in.
- Contact your broker to enquire whether they can assist you in the IPO process. Often, interest must be registered with a broker well in advance to receive access to the investment opportunity.
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