Everyone loves easy money - if this were not true, lotteries wouldn't be a trillion plus dollar industry. Investors in the stock market are no different, however the lottery they chase is called an initial public offering (IPO).
No matter what the stock market is doing, there is always interest in IPOs. Most investors in the stock market will not get in on the "ground floor" of these often exciting offerings, however there is always interest.
IPOs appear to offer investors the opportunity to get in on the ground floor of a potential new stock superstar. More often than not, the stocks turn out to be bit players at best and financial disasters at worse.
When the stock market is in a slump, the number of IPOs drop dramatically, but there are always companies waiting for some optimism in the market to launch their companies. What happens when a company "goes public" and how do average investors participate?
Companies start out as privately owned with a few investors contributing the money to get the business started. At some early point, companies often turn to venture capital companies for early funding.
Venture capital companies raise money from investors and then buy into companies in the early stages of development, although some companies that have been around for years can make the switch from private (stock not traded on exchanges and few investors) to public.
As a business grows, it needs more money to fund expansion. Companies can borrow some of the money, but it must be paid back with interest, which can slow growth down. If the company wants to expand beyond its local market, more capital will be needed - usually much more than the company could borrow.
The way many companies choose to raise this capital is by offering shares of its stock to the public. The initial public offering is a highly regulated event. The Securities and Exchange Commission (SEC) has a stringent set of guidelines that the company must follow during the process.
The SEC is the main regulatory agency responsible for monitoring the stock markets and securities industry. It must approve all IPOs and requires frequent and regular filings from publicly-traded companies. It is a watchdog for investors to protect them against unethical investing practices.
One of the documents the company produces is a prospectus, a legal summary of the business, its principal officers, its competitors, and detailed financial records of the company's history to date. One major feature of the prospectus is a listing of all the risks involved in investing in the company. If you have ever read this portion of a prospectus, you may wonder why anyone would ever invest money in this company. Almost everything that could possibly go wrong is listed, even though most of the events are remote possibilities.
When all the legal paperwork is complete to the regulatory authorities' satisfaction, a date is set for the offering to the public. An investment banking firm is responsible for bringing to stock to market and setting the initial price.
Investment banking firms are large financial institutions that handle the initial distribution of shares during an IPO. They sell shares to national and regional brokerage firms who in turn sell them to their best clients.
This is an important chain of events because the price may (or may not) jump significantly before any shares are actually available to the public. This is where the problem begins. Once shares are offered on the market, supply and demand for the IPO drives the price up or down.
IPOs have a mythical quality on Wall Street because of all the stories of stocks coming out and being bid up several hundred percent in price the first day. That was the case during the tech stock boom of the 1990s; however, with a few exceptions, that fever has died down in the recent past.
Even though much of the madness has faded, prices for IPOs often jump dramatically on the first day of trading. The question facing investors is will the price continue to rise or not. Frequently, during the first days of trading, some of the investors who got in early will sell for a nice profit, which often has the effect of driving down the stock's price.
If you got in at a higher price, your IPO investment may turn into a loss quickly. If you are lucky and the company has solid prospects, you may see the stock's price rise over time until you are out of the loss. Or, you can sell the stock quickly, take your loss, and move on.
Either way IPOs are often not a good deal for long-term investors. You are better off waiting for the stock market to settle on a realistic price and then decide if the stock is for you.
If you want to play the IPO trading game and try to guess when to buy and when to sell, do so with money you can afford to lose and remember, trading (quickly buying and selling) is not investing.