What would you do if you had a time machine? Go back and see the dinosaurs? Warn the Titanic about an iceberg ahead? Or maybe just ensure your parents still got together at the high school dance?

All are good ideas…but the answer many people give is often some variation of, “I’d tell myself to buy Apple stock in 1995.”

There are an infinite number of investing ideas, but getting in on the ground floor of a company before it takes off is perhaps the most enticing idea of all. For this reason, nothing catches the investing world’s attention quite like an initial public offering. An IPO is when a private company sells shares of its stock to the public for the very first time. It’s the quickest way for a business to raise capital…and the only way for an investor to snag a seat on the rocket ship before it lifts off.

But an IPO also comes with major risks for investors. So, as there are a number of extremely high-profile IPOs on the horizon — for companies like SpaceX, OpenAI, Anthropic, and Stripe — we thought this would be a good time to review both the pros and cons of investing in an IPO and how it works.

THE IPO PROCESS. The first step a company takes after deciding to “go public” is to hire an investment bank to act as an underwriter. The underwriter’s job, among other things, is to act as an intermediary between the company and the public. To do this, the underwriter purchases all of the company’s shares at a predetermined price and then sells it to the public at a higher price in order to secure a profit. The underwriter also assists the company in preparing and filing the necessary legal and financial documents in order to go public.

Underwriting comes with a degree of risk, so if the bank cannot sell all of the shares it purchases, it must hold onto them. For this reason, the underwriter will often partner with other banks to form an “underwriting syndicate” to share the risk.

The next step is to create a prospectus. You’ve probably seen these before — they are long, technical, and the perfect cure for insomnia. But they also contain extremely important information, both for investors and for the Securities Exchange Commission (SEC), which oversees the whole process. The prospectus outlines exactly what the company does, its financial situation, how it’s managed, how it expects to return value to shareholders, and more.

Next, the company and the underwriters determine the actual offer price. (Remember, this has to be higher than what the underwriter(s) paid in order to turn a profit. The difference between these two prices is known as the underwriting spread.) The offer price is determined in a variety of ways. Expected investor interest. The share price for similar companies. The amount of capital that needs to be raised in order to fund expansion. Expected future cash flows. Whatever the formula, it’s critical that they get it right. Setting the offer price too high can lead to unsold shares. Setting it too low means potentially leaving money on the table.

Then comes the roadshow…so named because it’s like when a traveling circus comes to town. The company will unleash a storm of marketing, press releases, and media appearances to drum up interest in the IPO. Through it all, the underwriters may issue new prospectuses, change the offer price, or move the IPO date forward or backward, all while remaining compliant with SEC regulations.

Finally, we have the IPO itself. The company’s shares are listed on a specific stock exchange, like the NYSE, and investors can begin purchasing as many shares as they want or can afford…although in truth, the vast majority of shares are usually purchased by institutional investors like mutual funds than by individual retail investors.

The Pros and Cons of Investing in an IPO. So, now that you know a bit more about what IPOs are and how they work, the question becomes: Should you participate in them?

Most IPOs come and go without major fanfare. Sometimes, though, when an already-famous company announces an IPO, it becomes a much-anticipated event. (Some recent examples include Visa, Facebook, and Uber.) When this happens, it can be highly tempting to invest. After all, the pros are obvious. Some companies become superstars, and their share price may never be more affordable than when they first go online. (Hence, going back in time to tell yourself to buy Apple stock.) You may also be a great believer in the company’s mission and have reasons to cheer for its success that go beyond material gain.

But IPOs also come with some very definite risks. For starters, consider our hypothetical time machine. There’s a reason people talk about traveling back to the past to tell themselves which companies to invest in — because we can’t look into the future! Many IPOs never match the hype and eventually fall by the wayside or sink into the masses. For every Apple, there are dozens of companies you’ve never heard of. That makes investing in an IPO exceptionally risky, because you’re banking everything on what is, essentially, a gamble.

IPOs can also be extremely volatile. As investors rush to hop on board, or look to make a quick buck, a company’s stock price can change rapidly until it achieves equilibrium. Facebook is a good example of this. After an initial burst of excitement, its stock price quickly fell. In fact, it took over two years for the stock to rise above its initial offer price! For many investors, that can be a long time to wait.

Furthermore, many companies see a steep drop a few months after their IPO. That’s because of something called the lock-up period. When a company goes public, company insiders — like owners and employees — are legally prohibited from selling their shares for a predetermined length of time. This period can be as few as three months and as many as twenty-four, but when the lock-up ends, the stock price may drop as those insiders finally begin selling their shares. For these reasons, investors should think very carefully before investing in an IPO. (They should also keep in mind that they might eventually own shares in the company anyway through the funds they’re already invested in.)

As we mentioned, there are several high-profile IPOs that will soon make headlines in the media. So, if you ever have any questions about IPOs, and whether they fit your overall strategy, please let us know!

Sincerely,

Barbara B. Hudock CIMA®, CPM®
Chief Executive Officer
Founding Partner

Michael J. Hudock, Jr., CPM®
President and Founding Partner
Wealth Consultant