Initial public offerings boomed in 2020, more than doubling the number of companies that issued new public shares year over year. The 482 recent IPO’s listed on U.S. exchanges in 2020 were the highest in the past 20-years, eclipsing the prior high of 397 in 2000. Several stocks that made their shares public saw considerable increases in their stock price, but not all companies were initially successful. There are several risks when trading IPO’s. Given the increase in taking a company public, 2021 is likely to be a banner year.
Why Does a Company Go Public?
An initial public offering is the first issuing of shares in a company that is reading for trading. The shares of a company might have exchange hands privately before the initial public offering. Still, for most investors, the IPO is the first opportunity to own shares in a private company. There are several reasons why a company decides to go public.
When a company issues public shares, it can raise capital. It is also a way for the owners of the company to monetize their investment. They can exit their previously held private shares to the public when the IPO occurs. When a company goes public, it needs to receive regulatory approval, which provides some credibility. The process also reduces the cost of capital, as a public company can use its stock as a means of payment.
The cons include an increase in regulatory requirements and disclosures. The owners of the company face the potential loss of control. Earnings and revenues need to be reported quarterly, which can place additional market pressure on the company’s management.
How Do You Trade an IPO?
The first step is to find a company that is planning an initial public offering. You can do this by searching S-1 forms filed with the Securities and Exchange Commission (SEC). To partake in an IPO, an investor must register with a brokerage firm. Many brokerage firms have eligibility requirements. You might have to have a specific amount of capital in your account. You might need to transact a certain number of trades. You might even need to have a particular net wealth. Your broker might provide some of the shares given to them to distribute during the initial public offering. Once an IPO price is set, your broker will be notified if you will receive any shares in the public company.
Risks to Trading an IPO
It would be best if you were skeptical when you trade an IPO. There is always a lot of uncertainty surrounding IPOs, mainly because of a lack of available information. You should know that it is difficult for the average investor to acquire shares in a healthy company about to go public. Brokers generally save their IPO allocations for their best clients. Unless you generate a lot of business for a brokerage firm, getting a robust portion of shares is small.
Another risk you take when you trade an IPO that prices don’t always move higher. While most IPO’s have a lockup for their owners and managers, some allow a specific allocation to be sold immediately. An IPO lockup is typically 90 to 180 days after an IPO, during which company insiders cannot sell shares. This usually applies to founders, owners, and managers of the company. Some IPO’s are issued and no lockup is required. This situation means that shares might be sold right away, putting downward pressure on prices.
The Bottom Line
IPO’s can be a great way to generate income if you find a robust company. To get an allocation of shares when a company IPO’s, you need to get them through your broker. In many instances, your broker will only give shares to their best clients. Risks include a lack of a lockup that allows insiders to sell their shares immediately. Additionally, some new IPO shares do not rise, do to the correct pricing of the IPO.