Investing in IPOs

Introduction

The 1990s have witnessed many small start-up companies successfully placing large amounts of stock in the primary market through well-publicized initial public offerings (IPOs). The possibility of buying stock in a promising start-up company and finding the next success story has intrigued many investors. Yet, is investing in an IPO right for you?

In this section, you will learn about some of the challenges, basic risks and potential rewards associated with investing in an IPO. You will be able to answer the following questions:

• What Is an IPO?
• What Should I Look for When Choosing an IPO?
• What Are the Risks of Investing in an IPO?
• What Information Should I Get Before Investing?
• Where Can I Find Information about the Company?

Even if you never invest in an IPO, the lessons you learn here will prepare you to make a decision about whether or not investing in an IPO is suitable for you.

What Is an IPO?

An initial public offering (IPO) is the first sale of a corporation's stock to outside investors. This does not necessarily mean that a company is a new business. It simply means that the company is offering shares of ownership to investors outside the corporate "family" for the first time.

Most businesses are privately owned. They do not have "outside" investors. A few people, who may be management or employees and members of their respective families, own all the outstanding stock. Such corporations are referred to as "closely held corporations." These companies are usually small, but some are nationally recognized names such as AVIS Rent-a-Car.

When a privately held corporation needs additional capital, it can borrow cash or sell stock to raise needed funds. Often "going public" is the best choice for a growing business. Compared to the costs of borrowing large sums of money for ten years or more, the costs of an initial public offering are small. The capital raised never has to be repaid. When a company sells its stock publicly, there is also the possibility for appreciation of the share price due to market factors not directly related to the company.

If you are looking for a "diamond in the rough," an initial public offering may be for you.

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What Should I Look for When Choosing an IPO?

As with any investment, you must do your homework carefully. Keep in mind that an initial public offering is a cheap way to raise capital. Investing in an IPO is not always best for the investor. Before signing that check, you must be clear about the benefits you hope to obtain from the investment. Are you investing for income, long-term growth or short-term capital gains? The offering's financials will tell the story.

• As an income investor, you need to examine the company's potential for profits and its dividend policy. You are looking for steadily rising profits that will be distributed to shareholders regularly.
• A growth investor evaluates the company's growth plan, earnings and potential for retained earnings. You are looking for potential steady increase in profits that are reinvested for further expansion.
• A speculator looks for short-term capital gains. As a speculator, you look for potential of an early market breakthrough or discovery that will send the price up quickly with little care about a rapid decline. You are not going to be in it that long. Companies that have "fad" products often fit the bill.

This sounds simple, but what are the risks involved?

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What Are the Risks of Investing in an IPO?

Slow down. It may sound easy, but it is risky. Before investing in an initial public offering, you need to ask yourself some questions. How much do you really know about this company? A Wall Street sage once said, "Never invest money in anything you don't understand." You may understand all about how an IPO works, but what do you really know about the business of the company in which you plan to invest? Before it went public, the only shareholders in a privately held company were the management, employees and their families. They all know about the business; they are in it. Before investing, you need to learn the fundamentals of the business. What is their product or service? Who are their competitors? What is their share of the market for their product? What is the likelihood they will succeed with their newfound capital? Ignorance is your worst enemy.

You should concern yourself with three kinds of risk related to the company.

• Business Risk: Does this company have a sound business plan and management with education, training, experience sufficient to execute the plan?
• Financial Risk: Is this company solvent with sufficient capital to weather short-term business setbacks?
• Market Risk: Are other investors likely to buy this stock on the secondary market? Does this company possess sufficient appeal to investors in the current market environment (income, growth, or short-term capital gains)? How long is the attraction likely to last?

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What Information Should I Get Before Investing?

The more information you have the better decision you will be able to make.

Keep in mind that the original stockholders are insiders. Among the information you will want to know is:

• Business Operations: What is management like? Do the employees like to work there? Is there a large turnover in the labor force? How do customers perceive the company? How do Dunn and Bradstreet and the Better Business Bureau rate the company?
• Financial Operations: What is the company's credit history? Are they in default on any debts? Have the owners invested sufficient capital to give them a financial stake in the company's success? How does this company's expenses compare to their competition's?
• Marketability: Would you buy and use their product? Who would? Is their product a long-term commodity or just a fad? Can you buy the IPO shares directly from the issuer?

A substantial advantage can be gained if you can purchase IPO shares directly from an issuer. This could save you "mark-up" and commissions used to pay for marketing the offering.

By taking the time to answer each of the questions above, you gain valuable information that will help you decide whether this IPO is a suitable investment for you.

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Where Can I Find Information about the Company?

Unless you actively seek out IPOs, the first you hear about an IPO is likely to be that dreaded dinnertime sales solicitation. Fortunately, all the information you need is readily available to you, but you must take the time to read it. Forget about the sales pitch. If the "…deal is too good to pass-up" and "… you must buy it tonight…" chances are you want to gain further information before investing.

Federal law states that: ALL INITIAL PUBLIC OFFERINGS ARE REQUIRED TO BE ACCOMPANIED OR PRECEDED BY A PROSPECTUS. The prospectus is the official offering document that contains all material information about the company and its offering.

If you are looking for an IPO as an investment, you should be familiar with the following:

• IPOs are often introduced in the financial press with a tombstone advertisement. This contains the "bare bones" information, including the name of the stock, the issuer and how to obtain a red herring.
• You may obtain a preliminary informational prospectus, red herring, to ascertain whether or not you have any interest in the prospectus and offering when available.
• Information about the offering is available on the Securities and Exchange Commission's Edgar database at www.sec.gov/edgarhp.htm.
• Today, many companies have their own web sites that provide information to their customers and prospective investors.
• Barron's, the Wall Street Journal, Investor's Business Daily and other financial periodicals report on companies going public.

IPOs are not for every investor. They may provide an opportunity for substantial gain for the knowledgeable investor, but the unwary investor is just as likely to get burned.

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