Editor’s note: This article was first published in December 2011; the recent IPOs it mentions, LinkedIn, Groupon and Zynga, are from 2011, and Facebook’s IPO, described as coming next year, took place in May 2012. SecondMarket was later absorbed into Nasdaq Private Market in 2015.
In financial jargon you often hear about “hot” IPOs: companies that decide to go public and are usually a real treat for investors, because high returns on the shares are practically guaranteed. The most recent and best-known IPOs have been LinkedIn, Groupon and Zynga, next year it will be Facebook’s turn, and in its day it was Google’s.
An “average” investor rarely gets into these deals, unless they are linked to an institution or the company itself gives them the chance to subscribe for the shares. Let’s say that IPOs are where you need some influential contacts in the stock market world, or to have worked with a broker who has received a block of shares to hand out among his most “valued” clients. As a general rule, though, these shares tend to go to institutions, financial firms, fund managers and big investors.
What is an initial public offering (IPO)?
An initial public offering is when a private company decides to sell its shares to the public for the first time, allowing investors to take part in the company’s growth. A company that wants to grow and expand can do so in two ways: take on debt or go public. With the second option, the company gets an injection of capital from the sale of its shares, although once it is listed it has to answer to its shareholders.
The advantage of going public rather than taking on debt is clear. If the company takes out a loan or seeks any other kind of financing, it has to pay the money back with interest. If the company doesn’t achieve the results it expected, it still has to repay what it owes to the bank or person who lent it the money. By going public, it is the investor who takes the risk: if the company doesn’t perform as expected, the investor who bought the shares is the one who loses. In return, the investor shares in the company’s profits.
How does an IPO work?
The first thing a company planning to go public does is hire an investment bank to manage the process and present the proposal and terms to investors. Among the investment banks most in demand among American companies for an IPO are Merrill Lynch, Lehman Brothers and Morgan Stanley, among others.
Together with the company, they will work out how much money to raise, how many shares to sell to the public and what type of shares to issue. Then they look for institutional investors interested in buying the company’s shares. Once they see that the shares are well received and in demand, the deal gets the green light. When the investment bank knows it will be able to place all the shares, it buys them and places them with investors. Up to this point, the whole operation takes place in a market that is very hard for small investors to access, known as the primary or private market.
Once the offer price is set, the shares are launched on the secondary market, where any investor can buy them.
How can a small investor get into an IPO?
As a rule, small investors tend to be left out of the whole IPO process, unless they already held shares in the company. Further down we explain how those shares could be acquired before an IPO.
Given that getting shares in an IPO is practically a gift for the investor, the investment bank first looks for big (institutional) investors. Second come its partners, and third its best clients, who tend to be clients the size of Arthur Rock or Warren Buffett (Buffett doesn’t invest in these companies). Of course, this “gift” also goes to family and friends, because make no mistake, it is a gift.
Sometimes there is so much demand for the shares that the number on offer is increased; on other occasions, faced with last-minute setbacks and difficulties, they don’t manage to place all the shares, and these end up being placed with small investors through intermediaries or brokers. It is usually a good idea to belong to an investment club, as these sometimes receive blocks of shares from IPOs to share out among their members (only sometimes). What I mean is that the more people and investment firms you deal with, the easier it will be to pick up good investment “bargains”.
Another way to take part in an IPO is to be a shareholder in the company before it happens. Doing it this way is very risky, as it is very hard to know whether you are buying cheap or expensive before the company’s real valuation is known.
Buying shares in a startup can be done by contacting the company directly or by using platforms where you can buy shares and bonds in companies that are not yet listed. At SecondMarket they tell me you can already buy Facebook shares, and even that Zynga had shares for sale. But then… what would be a reasonable price to pay for them? What will the shares be worth when the company goes public? If you get the purchase right and obtain the shares before an IPO, it could be one of the most profitable and lucrative investments you could make, but the risk involved would be out of all proportion to the return you could get.
Featured image: ProducerMatthew, CC BY-SA 3.0, via Wikimedia Commons.
