Learn The Basics Of How An IPO Works Before Investing

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These are exciting times when it comes to investing. The stock market is hitting all time highs. And IPOs are happening more frequently with so many startups going public. It’s a great time to get in on the ground floor of what can potentially be a successful new company.

Where there is money to be made, there is also a lot of hype. Pundits are keen to pump up many IPOs (Initial Public Offering) as they can create a lot of excitement. This hype can cloud the judgement and make people jump into scenarios that aren’t right for them. 

Not every IPO is going to pan out and some are bad fits for the type of investing that you prefer. In this article, we will go over the basics of what you should look into when it comes to investing in an IPO. 

What happens when a company goes public?

When a company is first formed, it is owned by the founders and financial backers or a combination that also includes the employees. It’s not up for grabs by the public and investors are not able to buy into the company unless one of the group decides to sell their interest to somebody. 

When an IPO happens it’s the company opening itself up to have anybody buy up shares in the company. These shares give them a literal share in the profits being made according to the amount of shares that they buy. 

An IPO is much different than an ICO or Initial Coin Offering of a cryptocurrency like Ethereum in which people buy up as many coins that they want and hope the coins gain in value. There is no stake in a company. 

When a company goes public, the stocks or shares are made available on an exchange like NASDAQ or the S&P 500. At this point anybody with a broker can buy as many shares as have been made available. Even without a broker people can buy their portion of the company.

Can anybody buy into an IPO?

In theory anybody can buy into an IPO. However, there are certain criteria that need to be met which will inevitably exclude many people. Every brokerage has their requirements. For instance, TD Ameritrade requires their clients to have at least $250,000 in assets with them or have traded stocks at least 30 times int he past year. 

Anybody that can prove eligibility can then buy into an IPO. unfortunately, it requires going through a brokerage firm and can’t be done individually through the exchange. Luckily, there are firms like E*Trade that will accept clients without asking for a minimum but they have to be approved by the underwriters. 

What makes it even more exclusionary is the fact that big clients are given an initial offering price. They can then sell those shares themselves on the big exchanges like the NYSE or NASDAQ. 

Create an account with a big brokerage

If it seems like you’ve been missing out on too many golden opportunities for getting in on an IPO then it pays to join a firm and get soem leverage that way. It will only make sense to do so if you plan to buy into IPOs frequently and as a big part of your investing strategy. Just testing the waters is not an option in reality and wouldn’t be worth the hoops to jump through.

It is more expensive to reate these accounts so be prepared for high brokerage fees and higher commissions. If you feel strongly that these IPOs are going to be something special then it will be worth it to spend the extra money for access. 

There are some online brokerages that can be used if you don’t want to deal with the big players. Fidelity, for example, has made a deal with many of the big banks like Deutsche Bank to get shares of an IPO that they can then sell to their clients. This may be the best option for people that are not looking to spend big and just want to see how the process goes. 

The last option will still see prices higher than what was offered in the opening round for the big banks, however. Regular people won’t have access to those prices unless the stock prices tank at some point. 

What are the risks?

Any form of investing carries some level of risk. Even companies that have been public for a considerable amount of time can prove to be bad investments. Even those with a good track record can lose value for a variety of reasons. 

IPOs are highly speculative, however, so investors take on an added level of risk when investing in one. For starters, the company has no history on its side that can be looked at and studied to understand how it might fare. 

Once the process passes the initial offering to big banks and hedge funds, then the actual IPO and finally onto the stock exchanges, they are at the mercy of the market. Some companies like Facebook go public and end up seeing a dramatic drop in value as soon as regular investors start cashing out once they make a bit of profit. Though Facebook shares increased in value over time and has proven to be a winner.

Other companies are not as lucky and founder when people start doubting the direction the company is taking. There are a number of factors that determine what companies will take off and which will flounder and fold. 

Conclusion

It is very tempting to give into FOMO (Fear Of Missing Out) when it comes to IPOs. This year seems to have a high number of successful ones that have made their investors a lot of money. 

Keep in mind the risks involved and study the company well before jumping in. Keep in mind that for every AOL there are many Netscapes so picking winners is not as easy as it seems. 


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