What You Should Know Before Buying IPO Shares

When private companies decide to list their stock on a major stock exchange, they participate in what’s called an initial public offering (IPO). It’s a way for the company to create liquidity for shareholders and raise capital by selling shares of the company to the public. The company can then use the newly acquired capital to grow the company.

The investment bank that underwrites the IPO attempts to set the initial price at the fair market value to maximize the sale proceeds for the new public company. If they set it too low the price will rise once trading starts and the company will lose out on revenue that they could have made had they set the initial price higher.

Earlier this month Zoom Communications and Pinterest both had IPO’s with first-day gains of 72 percent and 28 percent respectively. However, most investors don’t have access to IPO shares at the pre-trading price. They must buy when the market opens. Investors who bought on the open actually lost 1.6 percent on Zoom and made 2.7 percent on Pinterest. Not all IPO’s work well. In fact, investors might do well to avoid the IPO’s with the most hype.

Lyft, the ride-sharing competitor to Uber fell more than 30 percent from the price it started trading at. Facebook, one of the most anticipated IPO’s in recent memory, actually lost more than half of its value from where it began trading before eventually doing quite well. In fact, according to Barron’s, IPO’s have underperformed the broad market by a decent margin since 1980.

Many accredited investors are allocating a portion of their investments to private equity funds. These funds invest in younger private companies before they go public, typically at a valuation much lower than the IPO price. With access to private capital many private companies are growing to a much higher valuation before they go public. This means that there could be less potential upside in IPO’s than there has been historically.