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Initial Public Offering (IPO) Explained: 7 Things You Must Do Before Investing

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For a company, the Initial Public Offerings (IPO) represents a bureaucracy-filled rite of passage to go public. But, for investors, the right IPO can be a once-in-a-lifetime opportunity to capitalize on the long-term growth of the next Amazon or Netflix.

If you find the prospect attractive, you are not alone. But finding the unicorn and investing in a money-spinning IPO is more complicated than it seems. Here are the preliminary steps no buyer should overlook when approaching the world of IPO investments.

Find a Company That is About to Go Public

When setting off on the search for the right IPO to invest in, it’s important to know that all businesses looking to go public must register with the Securities and Exchange Commission (SEC) and meet strict financial criteria.

Once accepted, all companies that have filed a registration form (S-1 form) can be found in the SEC directory. On the other hand, investors are required to register with a brokerage firm, which will work as a medium, notify investors, and facilitate the IPO buying process.

Bear in mind that, if in the past 2 decades 206 IPOs were registered on average each year, 2021 represented a record year and saw over 950 companies go public. As the number continued to rise through Q1 2022, finding the right IPO to invest in might not be an easy task.

Read DRHP To Understand the Company, Its Mission, and Business Model

Once you have set your eyes on an interesting IPO, the next step is to look through the company’s Draft Red Herring Prospectus. The DRHP is an “offer document” compiled by a merchant bank and used by an IPO-making company when registering to the SEC (or SEBI in India).

The DRHP offers investors background information about the company, its reasons to go public, and potential risks and opportunities. Even more importantly, the offer document aims to show investors how the funds raised by going public will be used.

  • Pro tip - if the report mentions using the funds to repay outstanding loans, this can be a red light that the company isn’t able to repay its current debt. Green lights include using the raised money for research, development, or expansion.

Go Beyond the Prospectus

While the Prospectus represents a great starting point to research an IPO-making company, it is important to keep in mind that the offer document is compiled by the company itself, and not a third-party unbiased party.

At the same time, IPOs are high-risk investments and, even if looking for information about a still-private company might not be easy, you should strive to collect vital data, including:

  • Telltale signs of their reputation, including press releases and testimonials

  • The financial performance over time, such as revenue fluctuations and trends

  • The management and promoter team, as well as employees and partners

  • Key strengths and weaknesses

  • Valuations against industry parameters

Look For Market Opportunities and Gaps The Company Could Fill

Looking at the IPO-making company as a stand-alone entity might not be enough to understand how your investment will play in the future. Instead, before investing, it is worth looking at the industry the company operates in, its overall health, and gaps in the market that can be potentially filled by a new public company.

Research and Compare Investing Platforms

IPO investments are different from buying standard stocks. Firstly, most investors are required to register with a broker who offers IPOs and can mediate the investment. Investors looking to undertake this path might need to open a brokerage account, which requires meeting strict asset and financial criteria.

Alternatively, thanks to the advent of investing platforms like SoFi, retail investors can now enjoy greater accessibility to IPO investing and even complete the process through an online stock trading app.

  • Pro Tip - know who you are up against! The world of IPO investing has always been dominated by institutions and money managers who usually have the first pick on IPOs. However, if you are an individual investor with a long-standing and established reputation, new investing platforms allow you to compete against the industry’s giants.

Be Aware of The Implications and Risks of Buying an IPO Within the Lock-Up Period

Upon investing in an IPO, you are also probably designing your exit strategy.

Firstly, it is important to be aware of the legally binding contract known as the “lock-up period”, which prohibits investors from reselling their shares within a set term (usually 3-24 months). If an overvaluation is noted during this period and adjusted, you might not be able to sell your shares for the same price you have bought them.

Additionally, selling your shares just after the company’s IPO can lead to significant losses, because, once public, the stock’s price can change.

Ultimately, companies that have just gone public are not expected to perform extremely well in the short term. For example, just in 2021, stock values dropped on average by 14% in the six-month post-IPO period.

So, if your goal is to generate quick capital gains, this might not be the right choice for your portfolio.

Make Sure an IPO Belongs With Your Investment Strategy

Investing in IPO shares can lead to great returns for some investors. However, due to the limited publicly available information about the IPO-making company and the ties that come with such young stocks, IPOs are considered a high-risk investment.

Make sure they fit within your investment horizon and portfolio before buying.

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

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