Initial public offerings (IPOs) are milestones in the stock market calendar. An IPO is where a company gives the public an opportunity to buy shares in the company for the first time. This article will introduce you to initial public offerings and explain how to invest in an IPO.

Also, we will highlight some common pitfalls for IPO investors.

What is an IPO?

An IPO is the initial issuance of shares to the public, who ‘subscribe’ to the sale weeks in advance.

It is a necessary step which enables a private company to become a listed public company with a quoted share price and thousands of shareholders.

In an IPO, a company either:

• Offers new shares to the public, raising new funds to help the company expand. Therefore after the listing, the company will have more assets and more shareholders; or

• Allows existing shareholders such as venture capital or private equity investors to sell their stakes to the public. The funds from these sales go directly to the original owners of the shares. The company itself does not receive any financing and therefore remains the same size.

Once the initial offering or ‘primary sale’ occurs, the IPO subscribers can immediately sell these on the stock market just like any other listed shares.

Why do companies want to become listed?

1. They need to raise funds

As a company grows, it will usually need more money to fund their expansion, for example hiring new employees and purchasing equipment.

Companies have four main fundraising routes:

• Obtaining a loan from a bank
• Borrowing from the debt markets by issuing corporate bonds to investors
• Inviting private investors to contribute funds and receive some new shares
• Raise funds via an initial public offering of new shares on a stock exchange

Selling shares is preferable for larger companies which have already taken on an optimal level of debt. Debt is a useful way for companies to increase their return to shareholders, but the share price will begin to suffer if the debt burden becomes significant.

2. Public companies obtain cheaper funding than their private counterparts

As we explained in the Science of Diversification, investors demand a higher return from a riskier investment. In practice, this means they are prepared to pay a higher price now to receive a stream of dividends in the future if they will be exposed to less risk.

Quoted shares are less risky than their private counterparts. This is because:

• Quoted shares are liquid – an investor can sell their shareholdings on the same day.
• Executive managers tend to exercise better oversight over public companies. This is because regulations force them to comply with more stringent corporate governance requirements. This increases the focus on identifying business risks and monitoring conflicts of interest on the Board of Directors.
• Public companies have higher quality financial reporting. Regulations require them to develop robust internal controls to detect fraud and error. External and Internal audits subject the financial statements to a rigorous series of checks, which increases the trust that shareholders place on them.

As a result of this reduced risk, a public company is able to raise funds by selling fewer shares at a higher price per share, compared to an identical private company.

3. Listing creates an exit opportunity

A common motivation to go public is to provide an easy way for founders and early investors to sell their shareholdings at the best price.

It usually takes five years or more for a company to meet all the conditions for a successful IPO. By this point, many different shareholders will sit on the shareholder register. Some of these parties will be eager to find a way to convert their successful investment into cash.

Early investors could include:

• The founders
• Seed or angel investors (early-stage investors which help start-ups get off the ground)
• Venture capital funds (later stage investors which can provide large cash injections while a start-up is loss-making).
• Employees who have received shares
• Banks which may have converted their loans into shares

How does an IPO work?

Step 1: Building a team

The company brings several external experts and consultants on board. This is usually a selection of investment banks and an audit firm. Because IPOs are such rare events, a company will never have the expertise in-house to go it alone.

In addition, investment banks offer a service called ‘underwriting’. This is where, for a fee, they promise to step in and purchase any remaining unsold shares if there is insufficient demand on the day of the IPO.

Read more: Investment banking books, Consulting books

Step 2: Creating a Prospectus

With the assistance of the investment bank, the company produces a ‘Prospectus’. This document is subject to many rules and requirements. It provides insights into the operations, strategy and future plans of the company.

The prospectus includes three years of audited historical financial information. This allows potential investors to gain a broad understanding of the business to help them decide whether they want to invest, and at what price.

If you’d like to see an example of an IPO prospectus, check out Aston Martin’s prospectus from 2018.

Step 3: Setting a price

Through dialogue with potential investors together with their own analyst research, the investment banks help the company decide on a fixed price or a price range for their shares.

Setting the right IPO price is crucial. A company won’t sell its shares if the market believes they are overpriced. Any subscriber that pays a premium over the true value will suffer an immediate loss when the shares begin trading at their lower, fairer value in secondary trading when markets open the following day.

Therefore, companies deliberately underprice their IPO to ensure their success. Sometimes the discount is as high as 25%. An underpriced share is likely to ‘pop’ or rise on the first trading day as it aligns with its fair value. This price surge is a gift to all IPO subscribers. The prospect of a large ‘pop’ in the share price on day one drivers much of the excitement around IPOs.

Step 4: Creating demand

Behind the scenes and in the press, the investment banks use their network of contacts to drum up interest in the company ahead of the IPO date. The hype machine enters into full swing, while financial journalists begin speculating about whether the IPO will be oversubscribed.

If the bankers have chosen an appropriate price point, investors should not need too much convincing. However, if the stock market conditions become gloomy, or some negative press emerges during the IPO process, it can become a real struggle to keep the market consensus within the original price range announced.

Stockbrokers will contact their clients in the period leading up to the IPO, to offer them the opportunity to participate. Some stockbrokers email their client base about upcoming IPOs, but others will simply list them on the IPO section of their website. Beyond a stockbroker trading fee, no other fees are charged for an IPO.

Step 5: Going Public

The IPO itself – the primary sale – occurs the evening before the stock market allows secondary trading in the shares. An IPO that is successfully marketed, will be heavily oversubscribed. With too few shares to satisfy demand, shares are allocated to subscribers using one of two allocation methods. Which method is used will depend on how the final IPO price was decided.

• Fixed price – Shares are allocated across all subscribers proportionately to the order size.
• Price range – The book building method sees shares allocated first to the subscribers who placed orders at the top-end of the price range.

Depending on the allocation method, investors either have an incentive to over-order, or increase their subscription price, if they want to increase their chances of receiving the desired number of shares.

Recent IPO examples

We have compiled the following table to show the first-day share price performance of some recent high profile IPOs, compared to their IPO price.

Company	Date	IPO Price	Day One Closing Price	Gain / (loss)
Uber Technologies	10 May 2019	$45	$41.57	(7.6%)
Lyft	29 March 2019	$72	$78.29	8.7%
Fiverr	12 June 2019	$21	$39.90	90%
Avantor	16 May 2019	$14	$14.50	3.6%
Aston Martin	2 October 2018	£19	£18.1	(4.7%)
Beyond Meat	2 May 2019	$25	$65.75	163%

As you can see, some IPOs have delivered monumental returns on their first day. It also shows that some IPOs are ‘duds’, and lose their subscribers money. It isn’t necessarily rosier when we zoom out; the shares of Aston Martin lost 75% of their value in the year following its IPO.

Is investing in all IPOs a winning strategy?

One method to take advantage of IPO pops would be to invest £1,000 in each IPO opportunity and sell the shares one day later to realize any profits.

Unfortunately, this idea might not work in practice – even if it was used on the IPOs in the table above.

How could this be? Well, the missing link you need to appreciate is the issue of supply and demand.

When an upcoming IPO is widely understood to be deeply underpriced, it can become oversubscribed hundreds of times over. This shouldn’t surprise anyone – free lunches are very rare in the world of investing! Many investors who hear about it will also want to take part. This will include professional wealth managers and wealthy private investors with millions of pounds at their disposal.

With so much money chasing a relatively small number of shares, small investors get crowded out during the allocation process. Of your £1,000 subscription order, you may only receive £20 of shares!

Conversely, when an IPO has a lukewarm reception, its IPO might be undersubscribed. In these cases, your order will be fully allocated. The lack of enthusiasm in the IPO will bode poorly for the performance of the shares on their first day of trading.

You will feel the effect of being crowded out of the best opportunities, and left to saddle the full weight of underperforming IPOs. Therefore, this means that returns from this basic strategy are likely to be poor.

A more sensible approach

It logically follows that you should be selective when investing in IPOs. If a deeply discounted opportunity comes along, your stocks & shares ISA or stockbroker may give you the chance to participate.

However, to avoid disappointment at being ‘allocated’ down, you may need to use additional cash to ‘over-subscribe’ to the IPO. However, this strategy carries some risk. Because in the event of the IPO being unexpectedly unpopular, you may be left with a significant holding of unpopular shares!

Some opportunities remain

A notable exception to the trend of small investors being ‘crowded out’ was the listing of Royal Mail in the UK in 2016. The government-led allocation process protected small investors by giving their requests priority over any orders over £10,000. This allowed 350,000 small investors to make a £300 profit from the 44% pop in the share price on the first day of trading.

Learning more about IPOs

If you’re interested in beginning a career in a finance industry which deals with IPOs, look into the investment banking, venture capital and private equity industries.

Each is distinct, but offers a seat the table in which these IPOs are orchestrated.

• The best investment banking books
• The best venture capital books
• The best private equity books

Investment banks are hired to advise on a listing, and also use their network of clients to stimulate demand for the offering. Syndicates of banks also offer to underwrite a listing – providing a guarantee to the client that they will achieve a minimum fundraising on the day.

Venture capital and private equity firms may have stakes in the companies which list via an IPO. The IPO represents the end of the investment cycle, allowing them to finally convert their stake into cash and crystallise a profit on their investment.