Average investors tend to be left on the sidelines in favor of big funds when it comes to investing in initial public offerings at their offer prices, which can often be considerably less expensive than where the stocks end up trading as time goes on.
Moreover, only a small percentage of retail investors even know how to buy IPO stock at the company’s go-public price.
Investing in an IPO is risky but exciting, says Pam Krueger, founder and CEO of Wealthramp in Tiburon, California. While there’s a chance the stock can grow in value, which could leave you handsomely rewarded, there’s also the possibility that its shares will flop upon market debut.
“Lots of people assume if you buy early, the IPO will become a unicorn,” Krueger says, referencing stocks like Google parent company Alphabet Inc. (ticker: GOOG, GOOGL). “But it’s just as likely that the young company could also become a famous failure once shares begin trading.”
That said, to set yourself up for success, you should balance expectations with reality and have a strategy going into investing in IPO shares.
It can be much more difficult for average investors to buy shares in a traditional IPO and take part in the potential run-up in share prices once the company goes public. But this market is opening up as more brokerages are expanding IPO share access. If you want to find companies in their early growth stages, here’s what you need to know before you add IPO shares to your portfolio:
— What is an IPO?
— Types of IPOs.
— Who can buy IPOs?
— Risks of IPOs.
— When should you sell IPO stocks?
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What Is an IPO?
Companies start out with private funding to get started on their operations. As the company grows and expands, it needs more capital. To gain access to more funding, the company may decide go to the public markets with an IPO to raise money from a broad range of investors instead of getting money only from a bank or private investors. Investors who get in on the ground floor can reap the benefits as the company experiences growth, and as a result, investors can get a handsome return on their future investment if the company proves to be a massive success.
Investors trade IPOs because they believe a company will experience growth in the future. They see the company’s potential and want to get in early so they can capitalize on that investment before a company matures. As companies increase their value in the future, the public can invest and make money from holding shares of IPOs.
Types of IPOs
With traditional IPOs, companies that want to go public hire investment banks to sell shares.
The investment banks can team up to form syndicates, with each bank getting a certain number of shares. The banks offer the lion’s share to big institutional investors such as pensions, endowments or hedge funds in what is called a “roadshow.” Retail brokerages can end up getting shares, but they may make up only a small percentage of the allotment.
Most IPOs are done this way, but there is another type of IPO that gives retail investors a better chance of getting shares, known as the “Dutch auction IPO.” A Dutch auction is an initial offering where bids start at the highest asking price, which is then lowered until it reaches a level that best serves the buyer after all bids are submitted. This auction bidding model allows smaller investors to gain greater access in an IPO by selecting their own price and the number of shares they want to buy. The value and quantity can vary among investors. When all bids are submitted, every bidder ends up paying the lowest bidding price.
“A Dutch auction lets smaller investors actually become part of the pricing process and uses a ‘blind bidding’ to avoid price collusion,” Krueger says.
Instead of book running by investment bankers to try to secure a price, investors enter the price they’re willing to pay for shares via a website in a similar way to how Treasury securities are bought.
[Read: 6 Ways 2021 Changed the Investing Game for Advisors.]
Who Can Buy IPOs?
Brokerages play an important role in bringing investors access to the IPO investment. Those with a brokerage account at one of the big banks have a better chance. Outside of the big banks, full-service brokers with larger amounts of assets under management can offer more access to an IPO than the bare-bones, do-it-yourself-oriented online brokerages.
While some brokerages offer IPOs, they cannot guarantee investors stocks at the IPO offering price since they only get a smaller portion of shares once the company goes public. Even then, investors have a slim chance of buying these shares, especially if it’s a popular IPO.
Some brokerages, like Fidelity, have relationships with firms that provide investors access to IPOs. Depending on the underwriter, Fidelity users must meet certain asset requirements, like having a certain amount of assets in their Fidelity account, to participate in an IPO.
Other firms, like TD Ameritrade, also have eligibility requirements that if met, allow investors to put in a conditional offer to buy a new IPO, but this does not mean you are guaranteed shares.
More online brokers are offering IPOs with lower account minimums, but these users may not receive equal allocations of IPO sales. If there is a “hot” IPO that is in high demand from many investors, there is a lower probability of getting in. Rather, investors would have to start trading shares once the IPO officially goes public. Generally, your chance of getting IPO shares increases when you trade more and have a higher account balance.
The odds are not in the retail investor’s favor when it comes to participating in the IPO market, says Josef Schuster, founder of Ipox, a Chicago-based financial services company.
Institutional or accredited investors have the upper hand in getting dibs on most of the IPO shares, which can go quickly, especially if the IPO is heavily anticipated. “If the deal is ‘hot’ and demand is high, the competition from institutions will likely reduce the number of shares (that) investment banks will allocate to retail investors,” Schuster says.
Make sure to search your broker’s website for what requirements you need to meet and what hoops you’ll have to jump through if you want to buy IPO shares at their offer prices. For example, requirements to participate in an IPO via Fidelity include having either $100,000 or $500,000 in retail assets, depending on what companies are sponsoring the offering.
[SEE: 10 of the Best Investing Books for Beginners.]
Risks of IPOs
While a stock’s IPO price is the same for all investors, there is a disadvantage for individual investors in getting the best value for an IPO compared to accredited investors.
“The way accredited investors have advantages over retail investors in companies that come public is that oftentimes accredited investors invest in companies pre-IPO,” says Robert Johnson, professor of finance at Creighton University.
Accredited investors invest in companies that raise funding in the venture capital stage. During this stage, the investor takes on more risk because the viability of the company is still in question. Even though there is still risk in investing in an IPO, it is less risky than investing in the pre-IPO stage since the company has passed regulatory requirements to be listed on a major public exchange.
“Buying the IPOs of companies isn’t a guaranteed road to riches,” Johnson says. While companies raised a record $318 billion in IPOs in 2021, Johnson says the average IPO was a loser once it began trading, with a weighted basket of IPOs actually losing 3.7% in 2021.
When Should You Sell IPO Stocks?
Buying and selling a stock shortly after its IPO can be highly risky because the price of a stock once it goes public can be vastly different from its IPO price. Also, IPO stocks may not perform as expected in the short term. That said, investors may want to have potential exit strategies for their IPO stocks.
Stock traders may take a more tactical approach to IPO stock trades, having entry and exit points and looking at daily market movements. For long-term investors, short-term market movements may not be a grave concern, and they may be interested in understanding if an IPO stock is a buy-and-hold investment.
Let’s say you are an employee who owns stock options, and the company is about to go going public. There typically is a lock-up period where you aren’t able to sell the stock for a certain amount of time. But once that lock-up period ends, how can you make the right judgment on whether you want to keep it for the long term?
If you are concentrated in a position and not sure how the stock will perform, consider closing out some shares and seeing how the rest of your holdings play out over time, says Allison Ostrander, director of risk tolerance at Simpler Trading.
“There is nothing wrong with taking profits and giving yourself a nice cushion in your savings accounts,” she says. “But as long as you have over 100 shares of the company, you can always look to do covered calls … and create an income for yourself while still playing the shares long term to the upside.”
If you aren’t sure whether it’s time to sell an IPO stock, experts say to focus on the fundamentals.
“You should sell an IPO stock only when the company misses on earnings and reduces growth expectations during the first few sets of earnings reports,” Schuster says.
This may take several years to materialize, so for long-term investors, it may be worth it to wait and see how the company performs over time.
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How to Buy IPO Stock at Its Offer Price originally appeared on usnews.com
