Average investors tend to get left on the sidelines in favor of big funds when it comes to investing in initial public offerings at their offer prices, which can often be considerably below where the stocks end up trading as time goes on.
Moreover, only a small percentage of retail investors even know how to buy IPO stock at the company's go-public price.
Investing in an IPO is risky and exciting, says Pam Krueger, founder and CEO of Wealthramp in Tiburon, California.
But while there's a chance the IPO can grow in value, which could leave you handsomely rewarded, there's also the possibility that its shares will flop upon market debut.
"Lots of people assume if you buy early, the IPO will become a unicorn," Krueger says, referencing stocks like Google parent company Alphabet (ticker: GOOG, GOOGL). "But it's just as likely that the young company could also become a famous failure once shares begin trading."
That said, to set yourself up for success, you should balance expectations with reality and have a strategy going into investing in IPO shares.
It can be much more difficult for average investors to buy shares in a traditional IPO and take part in the potential run-up in share prices once the company goes public. But this market is opening up as more brokerages are expanding IPO share access. If you want to find companies in their early growth stages, here's what you need to know before you add IPO shares to your portfolio:
-- Why are traditional IPOs so exclusive?
-- Who can buy IPOs?
-- IPOs are risky.
-- When should you sell IPO stocks?
Why Are Traditional IPOs So Exclusive?
With traditional IPOs, companies that want to go public hire investment banks to sell shares.
The investment banks can team up to form syndicates, with each bank getting a certain number of shares. The banks offer the lion's share to big institutional investors such as pensions, endowments or hedge funds in what is called a "roadshow." Retail brokerages can end up getting shares, but they may make up only 10% of the allotment.
Most IPOs are done this way, but there is another type of IPO that gives retail investors a better chance of getting shares, known as the Dutch auction IPO. "A Dutch auction lets smaller investors actually become part of the pricing process and uses a 'blind bidding' to avoid price collusion," Krueger says.
Instead of book running by investment bankers to try to secure a price, investors enter the price they're willing to pay for shares via a website in a similar way to how Treasurys are bought.
But these types of auctions aren't very popular with companies going public, says Susan Chaplinsky, professor of business administration with the University of Virginia's Darden School of Business. These auctions tend to price company shares at the lower end of the prospectus range, she says. And retail investors have to know that the IPO is approaching, she says.
Who Can Buy IPOs?
For traditional IPOs, the ability for the average investor to get in on the action depends on their brokerage, says James Angel, associate professor with Georgetown University's McDonough School of Business.
Brokerages play an important role in bringing investors access to the IPO investment. Those with a brokerage account at one of the big banks have a better chance. Outside of the big banks, full-service brokers with larger amounts of assets under management offer better chances of getting in on an IPO than the bare-bones, do-it-yourself-oriented online brokerages.
Investing app Robinhood recently announced a rollout of IPO access to retail investors. This means that everyday investors have the chance to buy into companies at IPO prices.
"Firms like Robinhood are offering access to some IPOs," Angel says. "Time will tell how much of an allocation their customers will get of the hot IPOs.
The shares that brokerages do have tend to be allocated to better customers, Angel says. Generally, your chance of getting IPO shares increases when you trade more and have a higher account balance.
The odds are not in the retail investor's favor when it comes to participating in the IPO market, says Josef Schuster, founder of Ipox, a Chicago-based financial services company.
Institutional or accredited investors have the upper hand in getting dibs on most of the IPO shares, which can go quickly, especially if the IPO is heavily anticipated. "If the deal is 'hot' and demand is high, the competition from institutions will likely reduce the number of shares (that) investment banks will allocate to retail investors," Schuster says.
Make sure to search your broker's website for what requirements you need to meet and what hoops you'll have to jump through if you want to buy IPO shares at their offer prices. For example, requirements to participate in an IPO via Fidelity include having either $100,000 or $500,000 in retail assets, depending on what companies are sponsoring the offering.
IPOs Are Risky
One thing investors should ask themselves is whether they really want to invest on the ground floor of an IPO at all.
During a roadshow, the stronger the demand from institutional investors, the less will be available for retail investors, Chaplinsky says. The shares that trickle down to average folks can be the ones that "the smart money has declined," she says.
Also, there is now less underpricing than there was in the days of the dot-com bubble, meaning that buying a stock at the end of its first day or waiting a few days doesn't have to be as big of a disadvantage as it once was, Chaplinsky says. Companies can also have trouble maintaining their offer price if their valuation in the private market was more than what the public market is willing to pay, she adds.
In the past, evidence has shown that, in general, investors would be better off buying shares in a more seasoned company as there is a lot of risk in young companies, she says. That might be less of an issue nowadays as companies are going public later after more venture capital investment and additional years of development.
"You need to scrutinize these companies carefully," she says. "Just because they're coming public doesn't mean they're all going to survive and grow to be Facebook."
When Should You Sell IPO Stocks?
Buying and selling a stock shortly after its IPO can be highly risky because the price of a stock, once it goes public, can be vastly different from its IPO price. Also, IPO stocks may not perform as expected in the short term. That said, investors may want to have potential exit strategies for their IPO stocks.
Stock traders may take a more tactical approach to IPO stock trades, having entry and exit points and looking at daily market movements. For long-term investors, short-term market movements may not be a grave concern, and they may be interested in understanding if an IPO stock is a buy-and-hold investment.
Let's say you are an employee who owns stock options, and the company is about to go going public. There typically is a lock-up period where you aren't able to sell the stock for a certain amount of time. But once that lock-up period ends, how can you make the right judgment on whether you want to keep it for the long term?
If you are concentrated in a position and not sure how the stock will perform, consider closing out some shares and seeing how the rest of your holdings play out over time, says Allison Ostrander, director of risk tolerance at Simpler Trading.
"There is nothing wrong with taking profits and giving yourself a nice cushion in your savings accounts," she says. "But as long as you have over 100 shares of the company, you can always look to do covered calls (if the symbol will have options with it) and create an income for yourself while still playing the shares long term to the upside."
If you aren't sure whether it's time to sell an IPO stock, experts say to focus on the fundamentals.
"You should sell an IPO stock only when the company misses on earnings and reduces growth expectations during the first few sets of earnings reports," Schuster says.
This may take several years to materialize, so for long-term investors, it may be worth it to wait and see how the company performs over time.
Paulina Likos is an investing reporter at U.S. News & World Report, covering investing and asset management. Before beginning her career as an investing reporter, Paulina graduated from Villanova University where she studied political science, communication and business management. Out of college, Paulina spent several years as a risk manager at Fannie Mae, predicting and reducing credit risk for the company.
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