What is an IPO and should you invest in one?

But what does an IPO mean for you as an investor? Though this process may seem like an opportunity to buy shares of a new stock issuance and make a great deal of money, there are also risks, including losing much of your investment.

What does IPO mean? 

An IPO is the process of a private company becoming a publicly traded company. As part of this move, members of the public can buy shares of the company for the first time. This process is sometimes also referred to simply as “going public.” There are several steps a company must take in order to go public.

“The company hires an underwriter—typically an investment bank—to help value the private company and gauge interest in the shares,” says Andrew Crowell, financial adviser and vice chairman of wealth management for D.A. Davidson. “The investment bank then sets the initial offering price for the shares. After the public offering, the shares trade on an exchange.”

IPOs are often viewed as an opportunity for the general public to make a lot of money, but that’s not always the way things turn out. There are a variety of reasons buying an IPO may not pan out as you hoped.

“Certainly, getting in on the ground floor of the next big thing has its allure, but that’s not assured,” continues Crowell. “Typically, the financials for the company when it was private are not as transparent or readily available. Further, the initial share price set by the investment banker may overstate or understate the actual value of the underlying enterprise.”

Why do companies go public?  

There are many different reasons why a company decides to go public, and all different types of companies may opt to take this step—both old and new. In many cases, IPOs typically take place when companies are seeking to raise money to help pay for continued growth or pay off debts. Going public may also provide liquidity for investors and employees.

• Raising capital: When a company is private, it has fewer options to raise the capital needed for expansion or funding ongoing operations. But once a company goes public, it can start offering sales of stock to raise more capital.
  
• Creating exit opportunities: Long before a company goes public, early investors have the opportunity to purchase shares in a private company. But reselling these private shares can be complicated and may result in lower valuations because the shares are less liquid than those of publicly traded companies. Going public can offer early investors a way to sell shares to the public. “Think of venture capital firms or angel investors that may have invested a significant amount of capital early in a company’s life cycle that now want to reap the rewards of the risks they took with their investments,” says Brian Walsh, certified financial planner and senior manager of financial planning at SoFi.
  
• Enhancing liquidity for employees: Similar to early investors, employees at private companies who are compensated in equity or shares of the company have fewer and more complicated options to sell their shares. Going public, however, puts a market-driven price on the equity that companies provide employees, which can also enhance recruiting and retention. 

How to invest in an IPO 

Participating in an IPO involves buying a company’s stock at the offering price—meaning before it actually begins trading. Unfortunately, not everyone will have access to such purchases. At least, historically that was the case.

“Typically, everyone does not have the ability to invest in an IPO at the IPO price,” says Walsh. “During the IPO process, the company will engage an underwriter who helps structure the process and generate investor interest. The underwriter has the ability to allocate shares of the IPO based on their preference and agreement with the company. For example, an underwriter may only offer access to institutional clients or clients with certain balances.”

Over the past few years, however, the exclusivity of IPO purchases has eased somewhat. This is in large part because tech-oriented financial institutions, such as SoFi and Robinhood, have begun offering access to IPOs to everyday investors.

Here are some of the other ways to invest in an IPO.

Brokerage purchase 

It may be possible to buy IPO stock through a brokerage investment account, but not all brokerages handle these types of purchases.

“If your brokerage company has [IPO] shares that it can allocate, then you may be able to invest in shares, if they are allocated to you, after submitting your interest in the offering,” continues Walsh. “Different brokerage companies allocate their shares in different ways, so it is important to understand how your brokerage works.”

It’s also helpful to remember that, especially for headline-grabbing IPOs, even if you are able to obtain shares, you might not be able to get as many as you want. This is typically because the company only has a certain number of shares available to allocate.

Mutual funds and ETFs

It may also be possible to purchase IPOs via mutual funds, closed-end funds, and ETFs that focus on investing in these types of assets. However, to be clear, many of these funds purchase the IPO assets in the days immediately after the stock starts trading, not before. 

“These can offer another way to gain exposure to IPOs or recently listed companies in a more diversified manner than simply investing all of your money in one company that’s going public,” says Walsh.

Some of the assets in this area include:

• First Trust U.S. Equity Opportunities ETF (FPX): This ETF is an index of the 100 largest U.S. IPOs.
• Renaissance IPO ETF (IPO): This ETF offers a market cap-weighted index of recently listed U.S.-based IPOs. 
• First Trust IPOX Europe Equity Opportunities ETF (FPXE): For those interested in European IPOs, FPXE tracks 100 of the largest.
• First Trust International Equity Opportunities ETF (FPXI): Tracking an international index, this ETF includes 50 top IPOs outside the United States.

Pros and cons of buying an IPO 

If you’re considering investing in an IPO, it’s important to carefully consider the risks involved. While there are some benefits to this type of asset, there’s no guarantee your bet on an IPO will pay off, particularly, if the company is not well established.

Pros:

• Potential for significant long-term gains: Yes, there is a potential to make a handsome profit, but remember, it’s not a sure thing. The performance of IPOs historically is all over the map, with some doing quite well and others fizzling out. “If you choose the right IPO, it can offer an opportunity for large gains, but if you choose a majority of IPOs, data suggests that you may underperform the broader market,” says Walsh.
  
• Ability to help a company grow: For those with more altruistic goals, the cash you invest in an IPO allows a company to reach its goals for growth or expansion, or other needs. If you believe in a company and its offerings, buying IPO shares is one way to help support its success.

Cons:

• Less transparency: There is usually far less data or research available for prospective investors regarding private companies and their financials. This often means when you buy an IPO, you’re making a decision based on speculation. “While companies will file documents during the process of going public, you will not have as much information about the company as another that has been public for years,” says Walsh.
  
• IPO price may be inflated: Initial share prices established by the investment banker may overstate or understate the true value of the company going public. “Also, the company may be offering a very limited number of shares in the offering, thereby creating excess demand and further price discrepancies,” says Crowell.
  
• Equal potential to result in large losses: Finally, as already mentioned, IPOs may be exciting and inspire you to invest a great deal of money, and then the company may vastly underperform.

The takeaway 

Purchasing IPO stocks can be exciting and appealing, and may even provide the potential for significant gains over the long term. However, IPOs can be a very risky investment. Often, there is not a lot of research available about these previously private companies, so you’ll need to make much of your investment decision based on speculation. IPO ETFs and mutual funds can provide a safer way to add some of these assets to your portfolio.