< Blog
Investing

Should I Buy an IPO?

The next wave of initial public offerings (IPOs) are set to happen in the final month of 2020 and early into 2021.  IPOs were put on hold for much of 2020 as market valuations reached recession levels due to COVID-19.  As markets have now recovered and reached new all time highs, private companies want their stock listed at a premium price.  We are all going to become inundated with the acronym IPO.  Upcoming IPOs are company names we have grown familiar with over the past several years including Airbnb, DoorDash, Bumble, Instacart, Nextdoor, and Wish.  

Quick-trigger trading platforms now make it easier to buy these companies when they are on the open market.  We’re all searching for the next ‘unicorn’ stock.  Financial pundits will entice you to believe these IPOs are where you should be putting your hard earned investment dollars.  Before investing in these stocks you should first understand the process that these companies take going from a private company to a public company.  I’ll explain this process along with an answer to the question, “Should I buy an IPO?”

Definition

An initial public offering (IPO) is when a private company sells primary shares to the public for the first time and becomes a publicly traded company.

Process

  • The private company hires an investment bank after better understanding the investment bank’s pitch on what the company’s security type should be, their estimated price per share, and the financial goals of the private company.
  • The private company’s leadership, investment bank (hired), and additional resources perform market research to review current and forecasted revenue, competitor assessment, and risks to company growth.
  • The private company files a document with the Securities and Exchange Commission (SEC) called an S1 (Airbnb just filed this, read it HERE) which contains the company's historical financial data, company investors, company overview, company risks and executive compensation.  If you are interested in investing in a soon to be public company I’d HIGHLY recommend reading this filing.
  • The private company begins to meet with large institutional investors (think Wall Street) to begin assessing a price range for the offering.  This is done by reviewing the number of shares expected to be issued along with the company’s valuation.
  • The private company begins it’s roadshow, and just like everything else this year, it’ll be virtual.  The private company holds Q&A and begins accepting orders from institutional investors.  The private company is able to better understand the initial share price by interest.  For example if the company is selling greater shares than anticipated then it knows the price may be too low (a perfect example of  supply and demand).
  • After the dog and pony show, the company sets its final IPO price.
  • The equity syndicate team allocates the shares to the institutional investors interested.
  • Once the shares are allocated, the stock begins to trade and the public can buy and sell shares of the now public company.


Primary Market vs. Secondary Market

If you’ve ever purchased shares of a company on IPO day you might have experienced the fact that the talking heads on the news will state the “offering price” as a different price than what you purchased the shares at when the stock began trading publicly (also known as the “opening price”).  The reason that the IPO price is different than the opening price is because of the process I described in the previous section.  Shares are being traded and allocated on what is called the primary market.  People like us don’t have access to the primary market.  Again, the primary market is meant for large institutional investors such as Wall Street firms.  The company going public sells shares first of the primary market.  Then those institutional investors make the shares accessible to us on the secondary market.  The secondary market is where the different stock exchanges exist such as the New York Stock Exchange and the NASDAQ.


Should I Buy an IPO?

Facebook went public in May 2012 at $38/share. By September 2012 it was priced at $17/share.  Eight years later, Facebook is now priced at $284/per share.  Facebook’s journey stands out to me because of what my corporate finance professor taught me.  The valuation of a company is dependent on the present value of free cash flows better known as profitability.  At the time of its IPO, Facebook was perceived to have no revenue sources, which we now know is just not true. 

The price differences from May 2012 to September 2012 to present day can actually help us paint a picture of buying a new publicly traded company.  The share price on IPO day is typically above asking price in order to benefit the investment bank.  Think about it, they want to make money on the spread between the amount they pay for the issue and what the public pays to purchase shares.  I’ve heard the expression that an IPO actually stands for “it’s probably overpriced” because of this exact reason.

In addition to potentially being ‘overpriced,’ investors should also be aware of the ‘lock-up’ period for the company’s interested parties such as employees. The ‘lock-up’ period is a 90-180 day window when employees cannot buy or sell their stock position.  What can happen immediately following the lock up period is that the share price declines because employees can now trade their company stock whether that be restricted stock, stock options or other forms of stock compensation.  These employees may be selling not because of their outlook on the company, but simply to diversify away from the company that just gave them new found wealth.

Facebook has grown exponentially since it’s IPO.  Therefore, you may be thinking it’s still worth investing in, especially if you fast forward to 2020. If you have done the proper due diligence in understanding the company’s current fundamentals, growth prospects, and market risks it can make sense to buy a company at its early trading days for the long term.  If your plan is to purchase the company and dump it in the short term I’d advise you not to participate.  This is going to be difficult for many of us due to the platforms that make trading easily accessible..  

The answer should I buy an IPO is going to depend on your specific financial situation.  

Ask yourself...

  • What’s your appetite for risk?  
  • What’s the money truly going to be used for?  
  • What’s your time horizon?
  • Do I understand the company’s fundamentals?
  • What’s your target price to sell?
  • What percentage of your net worth does this company now represent? 

I’ve participated in IPOs during my career and have experienced both investment gains and losses.  I’ll admit that the losses have outweighed the gains.  I suppose this resonates with Nobel Prize winner Dan Kahneman and mathematical psychologist Amos Tversky in their study that found that investors feel the pain of loss twice as much as the joy of an equivalent gain. They’ve taught me to only invest in a company (or index fund) that I truly understand from company fundamentals, risks, and market conditions.

Now that you’re educated around the definition, process, and decision making structure of investing in a new publicly traded company I hope you make the decision that’s best for your financial wellbeing.


If you are an employee of a company going public and need clarity around your company stock or if you want personal guidance on purchasing newly issued shares please contact us for a free 30 minute consultation.


- Dan

Disclaimer: This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.

Dan Slagle
Founder, Fyooz Financial
Share:

Related Articles

Start your financial
journey now

Our goal is to help you understand how your asset allocation, tax allocation, and investment selections impact your financial goals. We actively manage our clients' investments.
Schedule a Free Consultation