How to Invest in an IPO
“ Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of euphoria” is a famous saying. No one knows who’s swimming naked until the tide goes out. In a bull market whichever share one touches rises. IPO’s are launched amidst much fanfare in a market filled with euphoria. One subscribes and oversubscribes these IPO’s. One reaches with both hands to grab a piece of the action. Greed clouds one’s reason and euphoria drowns what is left. Remember a bull market causes one to mistake himself for a financial genius.
Why does one invest in an IPO?
Entry at the ground floor Isn’t it logical for one to want to purchase a stock at its lowest price so that he can make a killing when the stock moves ahead at a rocketing pace? One then decides to enter at the ebb of the stock price and float to the top. One decides on an IPO as he believes that this is the lowest entry point or the lowest price he can purchase the stock for. Think …entry at the ground floor. But does this actually work?
- A Company funds itself through private investments. This usually consists of two to three rounds of investments funded by angel funds or venture capitalists. These are early birds who pick up the best worm. Venture capitalists spot a growing Company and fund it for an expansion in operations. This increases the price of the shares of the Company.
- Venture capitalists and angel funds take risks and expect to share in the growth and profits of the Company. They enter at a price which is dirt cheap and raise the value of the Company and consequently the share price. They truly enter at the lowest levels.
- Founders, Venture capitalists, Angel fund investors have invested heavily in a Company by taking huge risks. Remember the founder takes a huge gamble while starting the business.It is only right that they get a bulk of the profits and an IPO helps them attain this goal. The IPO helps them cash out a part of their investments and obtain great profits. Can one still think he has bought shares in an IPO at the lowest point?
- One has seen how rounds of funding raise the value of a Company and its share price. One sees that as the value of the Company rises more and more investor’s line up to make an investment. The share prices move steadily upwards. One sees the Company getting listed on the stock market in an IPO which is known as going public .This creates volumes and liquidity for the stock and promoters and venture capitalists get a huge return on investment as it is now easy to sell a part of the investment.
- Underwriters are appointed to take charge of the IPO and reach far and wide to tap good investors. Mutual funds and institutional investors are tapped .Underwriters have a feel on the pulse of the investor. They recommend a good price for the IPO as they would have to pick up unsold stock themselves if the IPO does not sell because of overpricing. In return the underwriter gets a part of the proceeds of the IPO maybe 5-6% of the proceeds. He too makes a killing on the successful IPO launch.
- Finally one invests in the IPO in a state of euphoria and the share price rises in a bull market. A bull market serves as a mask for an IPO .All Companies like to launch their IPO’s in a bull market. Next comes the hard bite of reality. The market prices in the true value of the shares and its price comes down. This does not affect venture capitalists as they have acquired stake at very low price levels. One unfortunately has no escape route.
Are all IPO’s which one invests bad?
- One needs to remember that not all IPO’s are bad and it is possible for investors to make a killing in the stock market by investing in a good IPO. One needs to withdraw from the mindset that any IPO is a good deal .While most IPO’s are good a few rotten apples get through. One needs to identify and carefully eliminate these from one’s portfolio.
- One needs to check the offer document and read it thoroughly in order to understand the business model of the Company. One needs to check the financials of the Company before making a decision to invest in the IPO. Always conduct a due diligence check, study of the management and a set of filters to set up a standard to pick up a good IPO and make a wise investment. Remember in life there are no free lunches. One needs to do his homework well.
- One needs to read the prospectus of the Company thoroughly before making an investment. One cannot afford just to glance through the prospectus with an attitude that this is just an add on .One needs to understand that the way a Company spends its money raised in the IPO is mentioned in the prospectus. If a Company spends too much of the equity raised in the IPO on paying back the promoters and loans raised by the Company then one needs to carefully weigh his options before investing. If the equity raised is going to be spent on expanding operations, market research and product improvisation then the IPO of such a Company should not be missed.
- Greed and euphoria are the prime factors which motivate one to invest in an IPO and one must be careful not to overlook certain very important details. One would see many Companies project financial figures and business operations in a highly optimistic light. One must check to see if the projected figures are within the realms of possibility. If not decide carefully before subscribing to the IPO.
What are the safety features incorporated in an IPO?
- One needs to check for a safety net incorporated in the IPO. What if the share does not rise above its listing price in the IPO? One has the price at which he is offered the issue. One needs to note that this price is very important as the shares issued in the IPO are bought back at this price. Many a time the promoter of the Company buys back the shares. One at least gets back the invested amount that he had subscribed to at the level the issue had been offered. This feature serves very useful as if the share price falls after listing one can at least recover the amount invested in the issue. Many IPO’s are known to offer this feature. Remember it is better to be safe than sorry.
There is a famous saying “Never look a gift horse in the mouth” .In case of an IPO this saying needs to be taken with a pinch of salt. An IPO is a great source of investment only if one does the ground work and due diligence in a proper manner. Remember a great tree grows from a small seed.