How to invest in an IPO

The IPO market has only grown hotter and more digital in the wake of the pandemic. A slate of newly listed companies have been celebrating virtual bell ringing ceremonies after virtual roadshows and video meetings with prospective investors since the spring of 2020. 

The market boom is powered by investor demand for new offerings, as well as ample liquidity. Investor appetite for young growth firms seems insatiable as nobody wants to miss out on the next Amazon or Facebook. The dramatic price increases seen after some recent high-profile IPOs have only further boosted demand. This trend looks likely to continue in 2021, especially if global central banks keep their easy money policy. 

But that doesn’t mean that IPOs are always good investments. They don’t guarantee huge profits at little risk. If you want to invest in an IPO make sure, as always, that you are well-informed as these offerings are considered risky and speculative investments. These stocks lack a trading history, a track record of reporting to investors and research coverage. 

What is an IPO, then? IPO stands for initial public offering. It is a transaction when a private company offers its shares to the public for the first time in a new stock issuance. The company is “going public,” which means that its private ownership becomes public and its shares will be listed and traded on a stock exchange. 

Why would a private company choose to go public? The main reasons are to raise funds to finance its expansion, to provide an exit for early investors, such as venture capital firms and angel investors, and to increase visibility

IPOs, direct listings and SPACs
The state of the IPO market

2020 was a banner year for IPOs. The IPO market reached a new record high in 2020 with the number of listings on the US stock market more than doubling, driven by the health care and tech sectors. According to Stock Analysis, there were 481 IPOs last year, compared to 233 deals in 2019. This is 20% higher than the previous record of 2000, which saw 397 offerings.

Number of IPOs per year on the US stock market

Source: Stock Analysis

2020 was also a boom year for alternative ways of going public, as companies increasingly look for new ways to tap into capital markets. These options include direct listings (Direct Public Offering) and SPACs (special purpose acquisition companies).

Direct Listings

In a direct listing, existing rather than newly issued shares of a company are sold to the public without the services of underwriters. So no new capital is raised and the issuer sells the shares directly to the public. In a direct listing, institutional and retail investors have the same access to the shares, with no allocation process. 

In comparison, in a traditional IPO the new shares are underwritten by investment banks and brokers who manage the IPO process. They buy the new shares from the company and then sell them to investors through their network. They also help set the offering price. 

There’s no bookbuilding and no roadshow either, which makes a direct listing less expensive, but more risky. Bookbuilding is the process of collecting indications of interest from potential investors, while a roadshow is a series of meetings with prospective investors. In addition to lower bank fees, the lack of lock-up restrictions is also an attractive feature of direct listings. 

Recent examples of a direct listing include Swedish music streaming company Spotify and enterprise chat platform Slack. Both companies’ shares are now traded on the New York Stock Exchange.

SPACs

SPACs are publicly-traded investment vehicles that raise funds via an initial public offering to acquire another company. The funds they raise through an IPO go into a trust and can only be used to buy an operating business. SPACs are basically shell companies without an operating business.

Investors in SPACs may include private equity funds, high-net-worth individuals, or the general public. In 2020 there were 248 SPACs, up from 59 in the previous year, raising $336 billion, according to data provided by SPAC Research

SPACs have been gaining popularity primarily because investors consider them a more efficient and less risky option with more transparent pricing, after having seen several successful transactions closing with the negotiated valuation. SPACs are also leaner than IPOs as they can skip several steps of the traditional IPO process.

Let’s take a look at Pershing Square Tontine, the largest ever SPAC, as an example. This SPAC raised $4 billion when it sold 200 million shares in an IPO in July 2020. The SPAC, which was founded by hedge-fund manager Bill Ackman, has two years to buy a private company using the raised capital. Ackman is reportedly eyeing “mature unicorns” and “high quality, venture backed businesses.”

Speaking of unicorns, they are all the rage in the IPO market. Unicorns are private companies valued at more than $1 billion. Recent examples of unicorn IPOs include food delivery company DoorDash and home rental platform Airbnb.

The Renaissance IPO Index

The Renaissance IPO Index can help you gauge the performance of the IPO market. The index, which tracks a basket of the largest, most liquid US-listed newly public companies, more than doubled in 2020.  

The index reflects the top 80% of newly public companies based on full market capitalization, is weighted by free float capitalization and imposes a 10% cap on large constituents. Companies that have been public for two years are removed at the next quarterly review. 

The top ten holdings in the Renaissance Index as of December 31, 2020
Name Industry Weighting
Peloton Fitness 9.9%
Uber Ride hailing 9.7%
Zoom Video Video conferencing 8.5%
CrowdStrike Cybersecurity 8.2%
Pinterest Virtual pinboard 6.8%
Slack Corporate chat 4.1%
Datadog Cloud software 3.8%
Avatantor Chemicals 3.6%
Palantir Data analysis software 3.2%
Lyft Ride hailing 3.1%

Source: Renaissance Capital

IPOs, direct listings and SPACs
How can you invest in the next hot IPO?

If you are a retail investor, it is difficult to directly participate in an IPO and buy the shares at the offering price. This is because the underwriters normally sell the majority of the new shares to institutional investors, such as mutual funds, pension funds or hedge funds. The remaining shares are sometimes sold to high-net-worth individuals. Retail investors typically comprise only a very small share of IPO buyers.

If you decide to try to directly invest in an IPO, first you need to find a company that is about to go public. If you want to track upcoming offerings, check the IPO calendars of major stock exchanges. The NASDAQ and the NYSE provide information about both the latest and the expected upcoming deals. Although you’ll find the most reliable information here, you should also check websites such as Google News and Yahoo Finance, to stay informed about all IPOs, not only about the issues that will be listed on these two exchanges.

Once you find an attractive upcoming offering, you have to submit an application to your broker for participating in the IPO and state the number of shares you want to buy.  Mind you, this doesn't mean that you get them. You may receive some, all or none of the shares you requested. Not much help, right? Due to these uncertainties, retail investors usually buy the new shares on the open market via their broker in the days following the offering. 

Also, let’s not forget that attempts at an IPO can fail. Remember when co-working company WeWork pulled its offering in 2019 after the SEC raised serious concerns about the transaction? And that wasn’t the end of the company’s misfortunes. CEO Adam Neumann soon stepped down under pressure and the company was taken over by Japan’s SoftBank Group in a rescue deal.

If you don't want to bother following the IPO market and you’re struggling with individual stock selection, you can always invest in IPO funds and ETFs through your broker. These are professionally managed and highly diversified portfolios. Moreover, you’ll get exposure to the new issuers before they get included in the main US equity indexes. 

Read the prospectus as well as the red herring

If you get the chance to invest in an IPO, read the prospectus first! This is the offering document in the registration statement, which will help you decide if the IPO is a good investment for you. A registration statement is a set of documents that a company has to file with the US Securities and Exchange Commission (SEC) before it proceeds with an IPO. 

Issuers use the prospectus to inform investors about the company and the terms of the IPO. Where can you find the prospectus? It is publicly available in the company’s registration statement on the SEC’s EDGAR database. EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval system. Access to EDGAR’s public database is free.

We recommend that you also read the preliminary prospectus, the so-called “red herring”. The somewhat strange name derives from the disclaimer in red on the cover page of the document saying that the registration statement has been filed with the SEC, but is not yet effective. The preliminary prospectus lacks key information, such as the price and the number of shares to be offered. 

Make sure that you read the latest version of the offering document too, because the prospectus is usually updated several times during the registration process. You might want to pay attention to the changes made from the “red herring.” 

The main sections of a prospectus are:

  • Prospectus summary
  • Risk factors
  • Use of proceeds from the offering
  • Dividend policy
  • Dilution, which is the disparity between IPO price and the book value per shares
  • Selected financial data
  • Management’s discussion and analysis in narrative form
  • Business, including products and services, suppliers and customers, competition
  • Biographical information on management
  • Financial statements and notes
  • Planned listings on a stock exchange, such as the New York Stock Exchange or NASDAQ. 

Source: SEC

After reading the prospectus, check as many independent sources as possible to verify the information provided by the issuer. 

In the meantime, feel free to check our article about how to buy IPOs by company name.

IPOs, direct listings and SPACs
How is the offering price set and what happens to the share price after the IPO?

The underwriters recommend a price to the issuer based on the valuation of the company and on the preliminary interest of potential investors. The process by which the offering price is determined is called bookbuilding. The order book lists how many shares each investor would like to purchase and at what price. The final offering price is set by the issuer. 

If you look at recent transactions you can see that some offerings were massively mispriced despite all that valuation and bookbuilding work. Why? 

IPOs can be overpriced because

  • The higher the offering price the more capital the company can raise
  • Underwriters make more money too, as their compensation is a percentage of the offering price

Or underpriced, as 

  • Underwriters aim to increase demand for the IPO by making prices attractive for investors
  • Underwriters underestimated market demand for the new shares

Let’s see what happens to the share price after the offering!

After the IPO, the stock will start trading publicly on the so-called secondary market. Remember that the trading price of new shares can differ widely from the offering price! So don’t be surprised if share prices are way below or above the offering price.

The initial trading is like a roller coaster. Expect dramatic price swings during the first days of trading. That kind of volatility makes buying the new shares immediately after the IPO risky. 

Let’s take a look at a few recent examples of aftermarket performance, i.e. how stock prices moved after an IPO.

Home-sharing platform Airbnb is a great example of lucrative first trading days. The offering price of $68 per share more than doubled on its debut to the stock exchange on December 10, 2020. The share price dropped a bit later, but remained well above the offering price. The Airbnb IPO was expected earlier but was delayed due to the initial impact of the coronavirus pandemic to the company. 

Security software company McAfee priced its IPO at $20 per share, but the shares closed below the offering price on the first day of trading on October 22, 2020 and remained there for months.

Watch these factors to better understand price movements following an IPO!

Underwriters often support the price of the new shares in the first days of trading to avoid short-term price fluctuations. Once this support ends, prices may drop sharply. 

The underwriters of a company’s shares may exercise a so-called greenshoe option. This is an option to sell additional shares within 30 days of the offering, mainly if demand for the shares is higher than expected. This overallotment option can also be used as a price-stabilization strategy 

The limited supply of shares is often the main reason why trading prices soar, especially after the most hyped-up IPOs. Why is the trading volume limited? There might be restricted shares when, for instance, existing shareholders have a lock-up agreement. That means that they can’t sell their shares for a certain period, typically for 180 days. In most offerings, companies sell only a fraction of their shares, with the remaining securities becoming available only six or so months later because of the lockups. 

Besides these restrictions, underwrites often discourage “flipping”, when investors who want to make quick profits try to immediately resell the shares acquired in the IPO on the open market. This can further limit trading volumes. 

Always check the market overhang in the prospectus. This is the number of shares that are not available for trading at the time of the IPO, but only after it. This could drive prices down. 

It may be wise to wait and let stock prices settle after the first tumultuous trading days. 

IPOs, direct listings and SPACs
What to expect in the coming years?

2021 is shaping up to be another strong year in the IPO market as the pipeline for IPOs, direct listings and SPACs remains strong. IPOs continue to be driven by the high level of liquidity on the market that has to be invested. The sectors that are expected to see the most listings are health care, especially the biotech subsector, technology and renewable energy, as these have the biggest potential to thrive in the current environment. 

Virtual IPOs and roadshows are probably here to stay even after the pandemic finally ends. They have certain advantages as they make the whole process leaner, shorter and less expensive. In addition, virtual roadshows allow smaller mutual funds outside of key US cities to get access to more prospective issuers and IPOs. Once the worst is over, there will likely be a shift towards a combination of virtual and in-person meetings with investors. 

Although they won’t replace traditional IPOs, the alternative ways of listing, such as direct listings and SPACs, are expected to continue to gain popularity. Moreover, SPACs that have already gone public are now searching for deals, which could also drive more private businesses to public markets.

Author of this article

Gabriella Lovas

Author of this article

Gabi loves writing new content, be it a broker review, an article on investing or a blog post. She enjoys every step of the writing process, from doing the research to editing. Working remotely from Barcelona as a content editor is both exciting and challenging for her.

Gabriella Lovas

Content Editor

Gabi loves writing new content, be it a broker review, an article on investing or a blog post. She enjoys every step of the writing process, from doing the research to editing. Working remotely from Barcelona as a content editor is both exciting and challenging for her.

Everything you find on BrokerChooser is based on reliable data and unbiased information. We combine our 10+ years finance experience with readers feedback. Read more about our methodology

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