Crocker Coulson Shares the Top Five Factors to Look for When Investing in an IPO

IPOs, or Initial Public Offerings, can be an excellent opportunity for an investor to participate in the growth of companies in the fast-growth stage of their lifecycle. Companies undergoing an IPO have frequently demonstrated that they have a viable business model and are ready for significant expansion. In this sense, they are less risky than venture-stage companies that are still seeking to prove that their technology works or that there is customer demand for their products or services. However, investing in an IPO is still risky because not all companies that go public demonstrate sustained appreciation in their share price. Some businesses may fail even after going public.

Crocker Coulson, CEO of AUM Media, which provides capital markets advisory services to pre-IPO companies, shares the top five factors that you should look for when investing in an IPO, explaining how you should consider each factor before putting any money into the offering.

What is an IPO?

An IPO or initial public offering is the first time a share in the company is offered by a private entity before it is listed on the stock market. Transitioning from private to public is an essential time for a company. It presents an opportunity for private investors to reap the initial benefits of their investment while allowing public investors to participate in the company's future growth of profits and cash flows through a combination of share price appreciation and potential dividends.

A company must go through the process of registering for a public offering with the Securities and Exchange Commission (SEC) and meet the listing qualifications requirements of the stock exchanges where it intends to list its IPO. But it is important to note that neither the SEC nor the stock exchanges opine about the advisability of investing in any particular initial public offering. For this reason, investors need to carefully consider the critical factors listed below before committing capital to any IPO.

Factors to Consider Before Investment in an IPO

The following are five factors that you should carefully consider before deciding to put your funds into an IPO:

1. Risk vs. Reward

IPOs are, by definition, riskier than investing in the larger, more established companies that make up familiar indexes like the S&P 500 or Dow Jones index. IPOs tend to be faster growing than such mature companies, and in an expanding economy and rising market, they tend to outperform the overall market. But they also may have less robust balance sheets and be at risk of underperformance during periods of economic stress.

“IPOs are a turbo-charged way to participate in the stock market,” said Crocker Coulson. “When economic conditions are favorable, and industries are undergoing rapid change, these are the companies you want to bet on since they are often the ones that have disruptive business models that will take share from established players. On the other hand, they may have marginal profitability, so when the market switches to a 'risk-on mentality, investors will gravitate towards 'safer' names with predictable cash flows and fortress balance sheets.'

2. Show Me the Money

Some people who invest in IPOs are in it for short-term financial gain. Given that most IPOs experience some level of the first day "pop" when they start trading, it can seem like a good idea to subscribe to an IPO and then "flip out' within days of the listing to take short-term profits.

But this strategy is inherently tax-inefficient and is a form of speculation rather than actual investment. If you intend to buy and hold an IPO for a period long enough to qualify for long-term capital gains, you want to make sure you truly understand the business model and how they intend to make money.

“The most important question you want to ask of any IPO is simple: ‘How does the company make money?” says Crocker Coulson, who has worked with dozens of IPOs and SPACs throughout his career advising late-stage private companies. "IPO companies are often in the cross-over period where they have just started to be profitable or EBITDA-positive or are on the verge of crossing over. But they should clearly explain how their gross margins and operating incomes transform as volumes scale to become a sustainably profitable business. If they can’t answer that essential question, it is a major red flag.”

Coulson noted that the one exception is biotech companies, which are often designed to be acquired by prominent pharma players who can more efficiently monetize their drugs once approved and may never reach profitability as a stand-alone entity.

3. Check the Burn

Investor interest at the time of listing may be high, but the company's sustainable business model and ability to survive to realize this vision cannot be ignored. If you are investing in the long-term, it is easy to get excited about a company that promises to facilitate interplanetary travel, sell flying cars, or other futuristic high concepts.

“Any company that is going public should be able to provide a reasonable timeline to reach transformational milestones with the proceeds that they are raising through the IPO," said Crocker Coulson. 'Investors should look closely at the historical cash burn and what management says about their use of proceeds. Investors should make sure that even if the IPO doesn't get them to profitability, that it at lets gets them to the next phase that justifies a higher valuation and lower cost of capital."

4. Emotional Considerations and FOMO

When people invest in IPOs, they frequently let their emotions run away with them. It is exciting to be involved with the initial stages of a new company, and the hype brings in many investors. The hype means that stock prices can quickly rise far above what would be considered reasonable based on the valuations and financial data supplied by the company.

It is essential to take a step back when planning an IPO investment and ensure that the price is not a bubble waiting to burst. Don't let the fear of missing out drive you to poor decisions when investing in an IPO.

"Keep in mind that there is always another 'once-in-a-lifetime' opportunity coming down the pike," notes Coulson. "It is very easy to get caught up in the money that you 'could have made by participating in the biggest winner that you read about in the media or that your neighbor brags about over cocktails. But keep in mind, people tend to keep quiet about the names where they broke even or lost their shirt. Given that IPOs are a high bet asset class, you are well-advised to engage in some level of diversification."

5. Reasons Why the Company Is Going Public

Companies go public for one primary reason: to raise money. Companies use the proceeds from an IPO to fuel rapid expansion, fund acquisitions, or pay down their debt. Watch out for IPOs (often sponsored by private equity funds) that are meant to eliminate debt. A 2017 study published in the Quarterly Review of Economics and Finance discovered that companies using IPO funds for these purposes are the worst underperformers in the first three years after going public.

“Unfortunately, the disclosures contained in most prospectuses are often less than illuminating," said Coulson. "'General corporate purposes' doesn't tell you much about how they will invest the capital to earn a high return. If you can get into a group meeting with management, press them on how they think about allocating capital they plan to raise, given that this will be a big factor in how effective they are in generating value for shareholders.”

Measuring the Consequences of Your Investment

When you follow these five tips from Crocker Coulson, you will be more likely to analyze your IPO investment closely. Understanding why IPOs perform the way they do is a significant factor in deciding whether you should invest in them. Having a solid understanding of the company's fundamentals and why it is going public can help you decide whether to invest, how much money to put in, and whether you want to invest in the short- or long term.

This article does not necessarily reflect the opinions of the editors or the management of EconoTimes