You Can Invest in a Company Before It Goes Public: Online Brokers Offering IPO Access
Initial public offerings (IPOs) are an exciting part of the stock market, but before you join in on the hype and invest in a company’s IPO, there are a few things you should know. Once shrouded in mystery and intrigue, IPOs have become accessible to anyone who wants to invest.
What Is an IPO?
A stock that is traded on an open exchange is known as a public company. This means that anybody who can afford to invest in that company may do so.
When a company first decides to offer ownership shares to the general public, it is known as an initial public offering or IPO. To do this, a company first must meet certain regulatory requirements for public companies.
Along with working towards meeting those regulatory requirements, a company seeking to issue an IPO generally works with an underwriter. This is a special kind of investment firm that will study the company and advise them on how much their shares should be worth on the open market.
The underwriter also helps the company drum up interest among investors. This mainly involves meeting with large institutional investors, professionals who are capable of moving millions or even billions of dollars into investments.
Creating interest in an IPO also generally involves a public relations effort to get the attention of retail investors. These are the ordinary individuals whose investments may be relatively small but are still important to stocks because there are so many of these investors.
Based on advice from the underwriter, the company sets an offer price. Investors are then able to sign up, or subscribe, to buy the stock at that price before it is even issued. However, access to those subscriptions is limited. Most people have to wait until the stock starts trading to buy the stock, at which point the price will move based on supply and demand.
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Risks and Opportunity of IPOs
Since all of the above is kind of a technical process involving a lot of paperwork, why are IPOs such a big deal?
The cliche that is often thrown around about IPOs is that they are like “getting in on the ground floor” of a newly issued stock. This claim is made because, under the right circumstances, you can buy an IPO before it starts trading publicly.
However, IPOs are typically not brand-new companies, so you aren’t really getting in on the ground floor. There are founders of the company who have put their money and time into getting the business off the ground. Often there are private equity investors who have put money into the company along the way.
These earlier investors expect some sort of return on their money, so they wouldn’t issue an IPO unless they could do so at a price that was attractive to them. These first investors are the ones who got into the company on the ground floor, not the investors who buy in once an IPO is issued.
Still, since some stocks really take off once issued, buying an IPO can be an opportunity to benefit from the market popularity of a stock. However, there are also risks involved.
Newer companies have limited track records of earnings for you to examine. They may not yet have proven that their business model can sustain the entry of competitors into their space.
Two other things add to the risk of IPOs:
- Many of the IPOs offered in 2020 are trading below their initial offering price.
- Larger numbers of IPOs tend to be issued when the market is feeling most optimistic, which can be a sign of a speculative bubble.
Not surprisingly, many IPOs actually underperform the overall market once issued.
How to Buy an IPO
Since IPOs are far from a sure thing, the key is to pick your spots. Look carefully at the financials behind the company, and the business model the company is pursuing. Consider the strength of the competition and the level of demand for the company’s products and services.
Also, compare the price of the IPO to the earnings potential of the company. It may be a good business, but if everyone already recognizes that, the stock may be issued at too high a price.
If you go through this process and are interested in buying an IPO, here’s what comes next:
- Find a broker that offers access to IPOs. Not all do. Otherwise you will have to wait until the stock is trading on the public market.
- Determine the issuing price of the IPO and how many shares you want to buy.
- Make sure you have enough money in your brokerage account to cover the amount you want to buy.
- Sign up with the broker to buy your target number of shares when the stock is issued.
Even once you do all that, there is no guarantee that you will get the number of shares you want — or any at all. If there is more demand for an IPO than there are shares available, the underwriters of the IPO and the brokerage firms they work with decide who gets the shares.
In that scenario, large professional investors are likely to get taken care of first. Ordinary retail investors are likely to be at the back of the line.
Of course, even if you don’t get shares of the IPO when it is first issued, you can then buy the stock on the public market once it starts trading. However, new stocks can be subject to wild price swings when they are first issued. Be careful not to pay more than the stock is worth as a result.
Online Brokers Offering IPO Access
Here are some examples of online brokers that offer retail investors access to IPOs. However, this doesn’t mean that each one will provide access to every IPO that comes out:
In many cases, you will have to meet certain qualifying conditions to be eligible to buy an IPO. These conditions may include the amount of money you have and your experience as an investor.
IPO Glossary: Key Terms to Know
Here is a glossary of some of the key terms you might come across when looking into IPOs:
Earnings. This is the profitability of the company. You can compare the IPO price to the earnings per share to determine how much you are paying for every dollar of earnings the stock generates.
Institutional investor. These are large, professionally managed organizations such as pensions and endowments. They are important to IPO investing because their size often gives them preference in the allocation of IPO shares.
Offer price. This is the initial price-per-share at which the stock will be available to investors who subscribe to buy it before the shares start trading publicly. Once the shares start trading, market sentiment will determine the price from day to day.
Prospectus. This is a formal disclosure document covering the financial and strategic details of the company going public. You should not buy an IPO unless you have examined the prospectus.
Public company. This is a company that has issued shares of stock that are traded on an exchange, where they are available for anyone to buy.
Retail investor. These are ordinary individuals who invest through brokerages, mutual funds, robo-advisors, and other means. Though their accounts are relatively small, the large number of these investors makes them an important influence on financial markets.
Share allocation. If there is high demand for an IPO, the underwriter of the IPO determines which brokerage firms will have access to shares prior to public trading. Those firms, in turn, decide how to divvy up those shares among their customers. This distribution is known as the allocation.
Subscription. In the context of an IPO, this is the process of signing up in advance for how many shares of the new stock you want. However, if demand for an IPO is high, you may not get all the shares you subscribed for or even any.
Underwriter. For an IPO, the underwriter is the financial firm that helps the company prepare to go public. The underwriter has a big influence on everything from the price at which the stock is issued to how the company communicates with investors to how the IPO shares are allocated.
FAQs About IPOs
If you follow the financial markets, you will generally see advanced discussions of upcoming IPOs. Also, if you do an online search for “IPO calendar” you should find several examples of schedules for when IPOs are planned to be issued.
Though there is generally less information available about private companies than public ones, the prospectus for an upcoming IPO is a great place to start. Also, think about who the company’s competition and target market would be, and learn as much as you can about those.
Not necessarily. While excitement about a new stock becoming available can cause a bump in the price after the stock is issued, this is by no means guaranteed. Some new stocks fail to live up to expectations and they underperform once issued.
No. In fact, in recent years, most IPO companies have had negative earnings when they first issued stock. This can be because they are going public to generate the investment capital they need to achieve enough scale to become profitable. However, there is no guarantee this will succeed, which adds to the risk of buying an IPO.
This depends on what you can afford, and how diversified your investment portfolio is. Keep a new IPO in perspective. Don’t buy more than you would typically own in your other stock positions. In fact, if the IPO is a smaller, more speculative company, you might want to buy less than your normal investment position.
