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Financial Literacy

IPO Market Tips: How Does It Work, and Should You Invest?

We live in a time when dorm room workshops can grow into technology giants within a few years. Measuring by market cap, five of the 10 largest companies in the world today are former tech startups. So it’s no wonder that the IPO market has gotten so much attention recently.

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There’s a lot of fanfare every time a startup goes public. (As an example, look at the upcoming Snapchat IPO.) But just because the media hypes up these events, it doesn’t mean you should invest…

The IPO market is a complicated and risky place. Let’s take a look at how it works.

How the IPO Market Works

First, it’s worth noting that an IPO does not involve a company selling its stock directly to the public. Like many other financial markets, the IPO market uses investment banks as middlemen.

An IPO starts when the company going public (called the “issuer”) enters a contract with an investment bank (called the “underwriter”). Under the contract, the issuer agrees to sell stock directly to the underwriter. The underwriter then resells it to retail investors.

These contracts come in a few different flavors. In a firm commitment contract, the underwriter pledges to sell a predetermined amount of shares. In a best efforts deal, the underwriter agrees to a fixed offering price but does not guarantee sale of all the shares. And in an all-or-nothing­ deal, as the name implies, the underwriter either sells all the shares or cancels the deal.

Once the issuer company and the underwriter investment bank have settled a contract, they move on to the paperwork phase of the IPO. The underwriter files registration forms with the SEC and writes an initial prospectus for investors. Then it takes this prospectus “on tour.” Its purpose is to pitch the new stock to bankers, billionaires and other high-roller investors.

Finally, once there’s enough enthusiasm about the stock, it’s time for the actual IPO. The issuer and underwriter set a final price and date. Then the underwriter sells its shares to the public.

Generally, the investment bank charges retail investors a slightly higher price for the stock than it paid to the issuing company. This way, the underwriter can collect a commission for its efforts. But it also means that the most lucrative part of an initial public offering isn’t actually public.

To buy shares at a discount, you generally have to be a bank or institutional investor. Equity crowdfunding is one way that an average Joe can act like an underwriter. But even if you get a sweet pre-offering deal, the IPO market isn’t risk-free. Some IPO’s mark the birth of corporate giants… but many others crash and burn.

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The Risks of the IPO Market

Past performance doesn’t predict future performance. But it can give you some hints about it. With a well-established stock, you can see how the price has responded to past scandals, economic downturns or other crises. But when you buy a stock in the IPO market, you’re venturing into uncharted territory.  The first piece of bad news that the public company gets could kill your investment.

Another unique risk of the IPO market is that it’s awash in subjective information. The efficient market hypothesis definitely doesn’t apply here. The issuer and underwriter don’t want to price in all the positive and negative information about the company.

That’s because they’re not acting like regular investors who want to trade the stock for profit. They’re more like used car salesmen. Their goal is to move units by any means necessary. And that means that if you trust them too much, they might sell you a lemon.

Perhaps the most memorable “lemon IPO” in recent years was Twitter (NYSE: TWTR). To an outside observer, Twitter looked like a successful stock in the making. It had powerful underwriters. It had tons of hype.

But Twitter’s inner circle knew something that the retail investors didn’t. The company didn’t have a functional business model yet. And it still doesn’t. As a result, its IPO gave it a totally unsustainable market cap. Ordinary investors got duped out of their money as the stock did this.

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How do you avoid losing 55% or more on a “lemon IPO” like Twitter? One surefire way is to avoid the IPO market. But if you’re willing to take the risk of buying a brand-new stock, do your own research. Know which banks are underwriting the IPO, and take their information with a grain of salt. Make decisions based on financial data, not based on pre-IPO excitement.

It’s like Warren Buffett always says, “Be fearful when others are greedy, and be greedy when others are fearful.” Now that you know how the IPO market works, you can realize the full potential of his advice.

Good investing,

Samuel


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