IPO Basics: Don't Just Jump In

Once a company has completed its IPO, its shares are tradable on public stock exchanges. Newly listed shares have their own set of risks and opportunities that must be considered before buying stock in a company that has recently gone public.

It's hard enough to analyze the fundamentals and technicals​ of an established company. An company about to IPO is even trickier to analyze since there is virtually no historical information to draw on. Your main source of data is the red herring prospectus, so make sure you examine this document carefully. Look for the usual information, but also pay special attention to the management team and how they plan to use the funds generated from the IPO. Often, investors will look to the performance of similar companies who are already public for comparison purposes, but many times an IPO involves a company that has no good points of reference. Also, pay attention to the quality of the underwriters and the specifics of the deal. Successful IPOs are typically supported by bigger brokerages that have the ability to promote a new issue well. Be more wary of smaller investment banks because they may be willing to underwrite any company.

If you look at the charts following many IPOs, you'll notice that after a few months the stock takes a steep downturn. This is often because of the expiration of the lock-up period. When a company goes public, the underwriters make company insiders such as officials and employees sign a lock-up agreement. Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The period can range anywhere from three to 24 months. Ninety days is the minimum period stated under Rule 144 (SEC law) but the lock-up specified by the underwriters can last much longer. The problem is, when lockups expire, all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.

Flipping is the practice of reselling a hot IPO stock in the first few days to earn a quick profit. This isn't easy to do, and you'll be strongly discouraged by your brokerage. The reason behind this is that companies want long-term investors who hold their stock, not speculative traders. There are no laws that prevent flipping, but your broker may blacklist you from future offerings or just smile less when you shake hands. Of course, institutional investors flip stocks all the time and as part of their everyday business. This double standard exists, so it is useful to be aware of it. Because of flipping, it's a good rule not to buy shares of an IPO if you don't get in on the initial offering. Many IPOs that have big gains on the first day tend to come back to earth as the institutional investors take their profits.

It's important to understand that underwriters and investment banks are salesmen. The banks underwriting an IPO want to sell their shares, so they want as much attention on and demand for those shares as possible. Since IPO’s only happen once for each company, they are often presented as "once in a lifetime" opportunities. Of course, some IPO’s soar high and keep soaring, but many end up selling below their offering prices within the year. Don't buy a stock only because it's an IPO, do it because it's a good investment and because you believe in the company’s future.

While a company can only IPO once, it can issue more stock at a later date through a secondary offering, which also uses the services of investment banks. Unless the demand for a company’s shares are quite high, a secondary offering may cause the price of shares to drop sharply as new supply is added to the market. It also may indicate that the company is on shaky financial ground and needs to raise more capital, but that they are unable to issue debt at a suitable cost.