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Understanding IPOs

How Companies Use IPOs to Go Public

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IPOs or initial public offerings are among the most exciting and closely followed events in the stock market. Although the excitement has cooled somewhat since the frenzy of the late 1990s when anyone with an idea that involved the word “Internet” could raise millions of dollars, IPOs still raise the market’s collective blood pressure.

IPOs mark the transition of a company from a privately held to publicly held firm. Every incorporated business issues stock, however there are usually just one, two or a few stockholders, since most businesses start out small.

These companies can’t sell stock to the general public beyond a small number of investors. If a company wants to raise a significant amount of capital without going into debt, one of the ways is to sell stock to the public.

SEC

Before a company can do this, it must register with the SEC (Securities and Exchange Commission) and prepare a public offering. This offering includes a prospectus and a number of other legal documents.

The prospectus is the accounting and legal equivalent of taking your clothes off. Everything good and especially bad or risky about the company, the senior staff, and majority stockowners is reported in the prospectus for the world to see.

The company contracts with an investment bank or banks to underwrite or handle distribution of the shares it wants to sell. The underwriters and the company agree on an opening price of the stock based on earnings or potential earnings and growth, but also what they think the market will bear.

If you would like to follow the IPO market more closely, this Web site Briefing.com provides a calendar of upcoming issues.

Markup

The underwriter then offers bundles of the stock to major broker clients who then offer first chance purchase rights to their big retail and institutional customers, with everyone along the way taking a markup of some degree.

By the time most investors get a chance to buy the shares in the open market, they have gone through several hands already and, if the stock is hot, the price is substantially above the initial offering price the company agreed to in the beginning.

Investor groups have complained long and loud about this and some reforms are in the works to give the average investor a shot at an IPO without a lot of sticky fingerprints all over it.

Making Money

There are two ways to make money with IPOs. First, you can jump in early and hope the stock has a big increase quickly, then dump your shares for a quick profit. This is not really investing, however if you can stand the risk and have the time to watch the market and are willing to do your homework, it is a gamble that can pay off. Just don’t bet your retirement or junior’s college fund on it.

The other way is to watch what is coming out and see if the stock is fairly priced. Find a price that you think is reasonable and grab the stock if you can get it at that price. If the shares are bid up early, wait for passions to cool and you may find the price back done to where it should be. In the dot.com boom, many of the IPOs that saw big increases in the first few days after issue were back new the original issue price after six months.

Conclusion

Despite the deck being stack against the individual investor, it is possible to make money with IPOs, but you must do your homework and set your limits in terms of what you are willing to risk.

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