What are IPOs and can I invest in them?

Left and right, people seem to be getting rich from Initial Public Offerings, or IPOs. Invest in the next Facebook or Apple right before it goes public and watch the profit flow in — how hard could it be?

Not so fast. IPOs tend to be well scripted affairs between the company issuing stock and those buying it. Canadians can legally participate in IPOs listed on the Canadian Stock Market, but cannot participate in US IPOs without some hurdles. Moreover, it may not be the best investment.

What is an IPO?

An Initial Public Offering is a private company’s way of making their company public. The company is able to raise capital by issuing debt, which takes form in  shares of stock, to the investing public. The shares produced by the company allows the public to participate in the investment market.

The initial investors in a private company are then able to realize a significant profit as their private shares are converted to public at the price offered on the market. The company, in turn, is able to access substantial funding to fuel further expansion.

Taking a company from private to public also comes with a number of required disclosures and transparency measures. The Canadian Securities Administrators, or CSA, governs publicly traded companies in Canada. The Securities and Exchange Commission is the United States counterpart.

As soon as a company is listed on an exchange, individual investors can buy stock in it. Some of the largest IPOs have garnered billions of dollars in funding. Alibaba, for example, raised $25 billion during their IPO in 2014.

But it’s not all fun and games. There is a con to every pro when a company initiates an IPO.

Pros

• The ability to raise capital by selling shares to the public

• Increased transparency (i.e. requirement of quarterly reports) generally allows for more favorable credit terms

• Many companies can offer stock as a part of a compensation package to attract higher caliber employees

• A public company can recognize a big lift in public image, often translating to better performance

Cons

• Very expensive; IPOs are really only for the largest and most successful companies

• Requirement to disclose earning statements and other documents that many not benefit the company

• Shareholders have voting rights and can exert more influence over a company, sometimes to the chagrin of its founders

• Moving share price often leads companies to chase profits over mission, product quality, or other items

In order to initiate an IPO, the company in question has to perform a number of crucial and complicated shifts in management, governance, and transparency. The company must form a board of directors who are looking out for the interest of the shareholders. It also needs to go through underwriting with a chosen financial partner, it often being a large global bank. The partner will go through the financials of the company with a fine tooth comb before applying for the IPO with the relevant regulatory authority. That bank will then work to attract initial investors in the business through a series of presentations and sales meetings.

These meetings are intended to do a number of different things. First, it will give the issuing bank and company a good idea about the appetite for shares of their business. Second, it will generate buzz and excitement for the stock as the IPO approaches, likely increasing the IPO pop that companies hope to experience. Finally,  the bank may increase their chances of becoming day one investors in the company before it goes public.

Sometimes, a company may choose to initiate an IPO via a direct listing. This means that they’re foregoing the underwriting process altogether. This can decrease the cost of the IPO but increases the risk for the financing bank.

"Some of the largest IPOs have garnered billions of dollars in funding. Alibaba, for example, raised $25 billion during their IPO in 2014."

How can I get in on an IPO?

Buying shares before an IPO goes public, otherwise known as the pre-IPO phase, can be very difficult to do. IPO stocks are often very popular and demand almost always outstrips supply. That’s because IPOs are expensive and as such, companies have a vested interest in ensuring that the shares go up in value. To achieve this, they rely on large and/or institutional investors to buy the shares immediately upon the open of the stock. This makes it very difficult for individual investors to get involved.

Sometimes, the individual investor can get involved in an IPO if they have a large, profitable relationship with the issuing bank (the bank who is bringing the company public). Often, the issuing bank will disburse shares to other financial institutions to sell to their clients. In this way, an individual investor may be able to participate. For the vast majority of investors, however, this is not possible.

Moreover, Canadian investors are not able to directly participate in IPOs based on US stock exchanges. Canadian investors are able to buy into Exchange Traded Funds or Mutual Funds in the United States that may take part in the IPOs of various companies. It’s important to note that there are a number of tax implications of doing so, both in Canada and in the United States.

What are these SPACs I keep hearing about?

Special Purpose Acquisition Companies (SPAC) are companies who have no products or services to sell. In fact, they often have no commercial activity at all. They are formed with the express purpose of acquiring a company. The SPAC will take investments from both large institutions and individual investors. That money is pooled in an interest bearing trust account that can only be dispersed to acquire a company or liquidate the trust and return the money to the investors. SPACs are often known as blank check companies because investors do not know what company the SPAC will acquire. This information is often kept secret by the creators to avoid extensive IPO requirements.

When the SPAC acquires the company, the dollars invested are converted into shares of the company. The company has essentially been taken public without the traditional IPO process. SPACs are generally reserved for large investors and retired executives who have plenty of capital. They are, by design, very expensive to buy into, lowering the number of individuals who have shares in the company acquired.

Are IPOs a good investment strategy?

All in all, IPOs can be thrilling. But, are they a good investment strategy? As with any investment, it is crucial that you build a balanced, well-diversified portfolio. If you have a solid foundation of other assets, retirement accounts, and liquid cash on hand for emergencies, an IPO can provide opportunities for growth that simply are not available in other investments.

However, it’s important to recognize that IPOs are volatile and far more likely to result in losses than a normal investment. While most IPOs will experience a pop on the first day of trading, there can often be holding requirements placed on initial investors. This means that you are required to hold a certain number of shares for a set period of time. That means you could be stuck holding onto a stock long after its pop has receded into quite the trench.

Both the United States and Canada have a plethora of financial education options for consumers. In Canada, the CSA offers investment basics explanations designed to help first time investors. In the United States, FINRA offers a variety of different calculators, how-tos, and important things to look out for.

It can be confusing and frustrating attempting to invest in IPOs as an individual investor. This is one of those things in the financial world where it truly helps to have a trusted investment banking partner to help sort out the particulars. If you’re ever unsure, try KOHO Premium free for 30 days, and set up a chat with our Financial Coach to help you understand what products and services are available to you.