What Is An Initial Public Offering?

Initial Public Offerings

An initial public offering, or IPO, is the first offering of a company’s stock to the general public on the stock market. This process is also commonly referred to as “going public.”

Why Have An Initial Public Offering?

While there are some substantial advantages for private companies to have an initial public offering and sell their shares on the open market. However, there are also some distinct disadvantages. The two must be weighed carefully.

Advantages

Private companies, which may have had a small amount of private investors up until that point, have IPOs in order to raise more capital to pay off debt, fund future growth, or to provide capital to fund daily operations at the company.

In addition, if the business has a high risk of failure, by offering shares of the company to the public, that risk is spread among many investors, instead of held only by a few private investors and the management team.

Another benefit for the company is that unlike debt, when capital is raised by issuing shares, there is no need to pay money raised by issuing shares back. This is cheaper for the company than taking on debt which will have to be paid back later with interest.

An initial public offering also gives private companies a chance to increase their prestige through the increased media exposure during the IPO process.

Disadvantages

The entire process of an initial public offering is not cheap or easy. Most private companies are probably better off not going public.

A publicly-traded company will have many laws and rules (accounting, corporate governance, securities, etc.), with which it will have to comply and many of those costs will be ongoing. One or more law firms specializing in securities law will also need to be hired during the initial public offering.

A public company is also required to disclose more financial and business information which may be of use to competitors. This may erode competitive advantages the company holds over their competitors.

Running a public company is different than running a private one. After going public, the management will not only have to answer to shareholders, but each and every comment will be thoroughly scrutinized, and be a possible cause for a change in share price.

How To Go Public

A private company interested in becoming a public company will work with an investment bank (like Goldman Sachs, J.P. Morgan, etc.), which will act as the main underwriter for the initial public offering.

As there is a lot of risk involved, a group of underwriters, referred to as a syndicate, usually also take part in the initial public offering.

The underwriter will guide the private company going public by helping to write the prospectus, pricing the shares, and handling the initial sale.

A registration is filed with the Securities and Exchange Commission, a preliminary prospectus, which is often called a red herring prospectus as it is incomplete, and then later the final prospectus that has been cleared by the SEC will be issued.

There is also a quiet period, a length of time of usually 40 or 90 days, where the company having a initial public offering must remain quiet in order not to artificially inflate the value of the stock. This period starts when the company files the registration statement with the Securities and Exchange Commission and ends when the SEC declares the statement to be “effective.”

An initial public offering is generally considered a success if the IPO runs smoothly and there is an increase in the stock price on the first day of trading on the stock market.

Lock-Up Period

During an initial public offering, company executives, employees, and early investors who were able to invest in the company when it was private, are restricted from selling their shares, for a period of 90 to 180 days. This is known as the lock-up period.

The length of the lock-up period varies, and it is based on the length of time stated in the contract that was agreed to by the executives, employees, and investors when they received their shares or options prior to the IPO.

The reason for the lock-up period is to try and prevent the stock price from dropping due to mass insider selling in the first few months immediately after the initial public offering.

Once the lock-up period ends, the stock price will tend to fall as insiders and large investors start selling their shares on the open market.

If you are interested in purchasing shares of a company having an IPO, it is usually safer to take your time, do your due diligence, wait until the lock-up period expires, and then consider buying shares if they trade at an attractive price.

However, in my experience, there still tends to be too much hype around a newly traded stock, and the stock price is usually too high for my liking, even after the lock-up period expires.

Unable To Build Wealth Buying IPOs

Risk

Initial public offerings are quite risky for the individual investor.

Normally, there isn’t much historical data to evaluate as private companies are have fewer reporting requirements. Therefore, there is less financial and business information about them available to the public.

It is particularly difficult to predict what the stock price will do, especially in the first few months of trading. It is not uncommon for a company’s stock that rose in the first few days to come crashing back down once the lock-up period expires.

Naturally, IPOs tend to happen when the stock market is overheated and hopeful investors are more willing to throw money even at companies that fail to make a profit.

According to Bruce Greenwald in the book Value Investing: From Graham To Buffett And Beyond, investment banks are able to make 7% on the money they raise in initial public offerings, which is much more than few pennies per share that they can make during ordinary stock transactions, so they are more than happy to take part.

Usually, when an initial public offering takes place, shares of the company going public are bought by large institutions, like banks and insurance companies, and sometimes by high-net-worth individuals, with connections to the investment bank or broker-dealer and they can buy the shares at the initial offering price.

Many institutional investors, will flip IPOs. They will purchase a large amount of shares at the initial offering price, and if demand causes the stock price to increase on the first day, they tend to sell their shares for a quick profit.

More often than not, regular investors like you and I, can only buy shares after the initial public offering, and not at the initial offering price. By that time, due to media coverage and pent up demand, the price has already increased and some of institutional investors are selling.

By the way, if you are not wealthy and do get offered a chance to invest in an IPO, be careful. Most likely, it is not an attractive company to own and the the shares are overvalued. If the shares were trading at a discount and the company was desirable, then the large investment banks and institutional investors would buy up all of the shares for themselves.

As you can see, at least with initial public offerings, Wall Street has already stacked the deck against little guys like us.

Performance

In the long run, academia has shown that at least for the individual investor, most IPOs will underperform the stock market as a whole.

For example, using the first day closing price and assuming that the average investor were to hold the stock for three years, Jay Ritter found that between 1975 and 1984, the IPOs significantly underperformed similar companies of the same size and industry in his 1991 paper The Long-Run Performance Of Initial Public Offerings.

Similarly, according to later research by Jay Ritter and Ivo Welch in A Review Of IPO Activity, Pricing, and Allocations, the authors found that if investors had bought IPOs at their first day closing price from 1980 to 2001 and held them for three years, then they would have underperformed the stock market as a whole by more than 23 points annually.

I think it is quite significant that both of these authors chose to use the first day closing prices when measuring the performance of initial public offerings, as that price most closely matches the price that most retail investors, people like you and I, would be able to purchase those stocks. Those prices more likely resemble “real world” stock returns that would be available to average investors.

I have read other academic papers which showed the opposite, that the buyers of initial public offerings will outperform the stock market as a whole. However, those studies chose to start with the initial offering price and then finished with the first day closing price, essentially just flipping IPOs, like the large institutional investors do.

Showing off his literary wit while commenting on the poor results of investing in IPOs, Jason Zweig, in the commentary of the 2009 revised edition of Benjamin Graham’s investment classic book, The Intelligent Investor shrewdly stated:

“Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for ‘initial public offering.’ More accurately, it is also shorthand for: It’s Probably Overpriced, Imaginary Profits Only, Insiders’ Private Opportunity, or Idiotic, Preposterous, and Outrageous.”

A Difficult IPO Path

As you can see, investing in initial public offerings is not for the faint of heart.

For every company’s stock that continues to rise from its IPO price, there are many more companies whose stock price drops significantly afterwards.

At least for the individual investor, the chance of successfully beating the stock market as a whole by investing in IPOs is quite low.

Key Takeaways

An IPO is the first offering of stock to the public.

Companies can raise cash by holding IPOs.

IPOs tend to underperform the rest of the stock market over the long term.

It is better to wait until after the lock-up period before buying shares.

IPOs are risky for individual investors.

References

Initial Public Offerings – Why Individuals Have Difficulty Getting Shares

http://www.sec.gov/answers/ipodiff.htm

A Review Of IPO Activity, Pricing, And Allocations (PDF)

http://research.ivo-welch.info/journalcopy/2002-jf.pdf

The Long-Run Performance Of Initial Public Offerings (PDF)

http://www.kellogg.northwestern.edu/researchcomputing/workshops/papers/ritter_jf1991.pdf

Why IPOs Underperform

http://www.cbsnews.com/news/why-ipos-underperform/

5 Reasons Investing In An IPO Could Be A Terrible Idea

http://www.businessinsider.com/5-myths-about-ipo-investing-2013-10

The Intelligent Investor by Benjamin Graham. 2009. Revised Edition. Commentary by Jason Zweig.

Value Investing: From Graham To Buffett And Beyond by Bruce Greenwald. 2001.

What Is An Initial Public Offering?
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