Investing in IPOs: What is it & How to Invest?

Ever considered investing in a company right when it hits the stock market? Investing in IPOs can be enticing but also confusing. This guide breaks down what an IPO is and offers straightforward steps to get started with confidence.

What is an IPO?

An initial public offering (IPO) is when a company offers its shares to the public for the first time. It marks a shift from being privately owned to being publicly owned, commonly known as "going public."

Both new startups and well-established companies might choose an IPO. The reasons vary. Some aim to gather funds to settle debts or fuel growth. Others want to boost their public image.

An IPO also lets company insiders diversify their investments or turn their private shares into liquid assets by selling them. Once a company decides to go public, it collaborates with a lead underwriter.

This underwriter aids in registering the securities and ensuring the shares reach the public. A team, including investment banks and broker-dealers, is then formed.

This team, known as a syndicate, handles the task of selling the company's IPO shares to both institutional and individual investors.

How to start investing in an IPO

Investing in an Initial Public Offering (IPO) can seem enticing, offering the potential to be part of a company's growth from its earliest stages. But how does one go about it?

Let's break it down step by step.

Do your homework before you invest

IPOs can generate a lot of buzz, especially if the company in question is a promising startup. This highlights the importance of doing thorough research before investing.

A good starting point is the company’s preliminary prospectus, often referred to as a "red herring." This resource details the company's management, target market, competitive landscape, financials, and even potential risks.

Participating in an IPO

Participating in an IPO means buying the stock at its offering price before it's available on the general market. This price is a collaborative decision between the underwriter and the issuer, taking into account various factors, including interest from potential investors.

Firstly, your brokerage firm needs to offer access to new equity offerings. Even if they do, they might have specific eligibility criteria.

Often, firms prioritize seasoned traders or those with substantial assets, understanding the risks involved in IPOs. A significant demand can outpace the available shares, making it even more challenging for individual investors.

Prove eligibility

Every brokerage has its own set of eligibility criteria. For instance, TD Ameritrade requires either $250,000 in assets or a history of 30 trades within the past year. Fidelity and Schwab have their own criteria, while E*Trade requires a specific questionnaire from the underwriters.

Request shares

Once you ascertain that you meet the criteria, you can request shares in the IPO. This doesn't guarantee you'll get all the shares you ask for. It's best to see your request as the upper limit of what you're willing to buy, contingent on availability.

Place your order

After the IPO sets its price, your broker will reach out with the final steps. They'll provide a deadline for your order placement. Once you place your order, you'll learn how many shares, if any, you've successfully bought.

Rest assured, you'll never be allocated more shares than you requested, and the price will always align with what you agreed upon.

10 Tips for investing in IPOs

Ever been tempted by the idea of getting in on the ground floor with today's tech giants? Investing in an Initial Public Offering (IPO) is enticing. It offers the promise of being part of a company's growth story right from the start.

However, diving into the IPO waters without guidance can be tricky. Here, we provide ten essential tips to help you make informed decisions and maximize your IPO investments.

1. Research independently

Investing in IPOs means investing in private companies, which often lack strict disclosure rules. This can lead to the hiding of vital information.

While experts offer IPO reviews, they base their insights on public data without a deep dive into the company’s operations or financial status.

Although the red herring prospectus provides a comprehensive view and has SEBI's approval, it's drafted by the company. This means they may omit any negative data. Therefore, before committing to an IPO, it's essential to conduct personal research.

Analyze the company's performance, evaluate the sector it operates in, and assess its growth potential.

2. Dive into the red herring prospectus

Investing in an IPO makes you an equity holder. Unlike debt investors, your capital isn’t safeguarded. Hence, familiarising yourself with the red herring prospectus is paramount.

This document, available on the company’s website, stock exchange sites, SEBI's platform, and various media outlets offers insights into the company's background, its promoters, reasons for public listing, inherent risks, and plans for the raised capital.

3. Understand fund utilisation

While the red herring prospectus outlines fund use, it’s crucial to know why a company is raising capital. If the objective is debt repayment, that might not augur well for potential investors. But, if the funds are for expansion or research, it indicates growth aspirations.

4. Evaluate promoters and management

Promoters often see IPOs as an exit strategy. Before investing, examine the track record and experience of the company's promoters. Equally vital is the management team. Renowned investors place high importance on management quality.

Strong leadership can steer a company through challenges and ensure investor returns.

5. Consider the brokers

Brokers play a pivotal role in managing IPOs. While big-name brokers tend to associate with robust companies to maintain their reputation, it's not a given.

Investing solely based on the broker's reputation is not advisable. It's vital to assess the company's fundamentals irrespective of the broker's stature.

6. Aim for the cutoff price

IPO investments are often seen as unpredictable. When investing, you bid within a specified price band. To enhance the chances of allotment, bid at the cutoff price.

7. Keep an eye on valuations

Determining the right valuation for a private entity can be challenging. Though professionals might gauge it based on returns and management quality, it's wise to establish your valuation criteria, by comparing the firm with industry peers.

8. Have an exit plan

For those looking at short-term gains, defining an exit strategy is crucial. Determine the levels at which you'll liquidate your holdings. Shares of commendable companies often start strong post-listing but might see a dip thereafter.

Whether you aim for short-term gains or wish to hold, having pre-set profit and loss thresholds is essential.

9. Understand lock-in stipulations

Retail investors should be aware of the lock-in period associated with shares. If underwriters offload shares post this period, it might indicate dwindling confidence in the company's prospects. Conversely, retaining shares during the period can be a positive sign, showcasing trust in the company's future.

10. Approach with caution

IPOs might seem like safe bets, but that's not always the case. With limited data available, investors often lean on broker advice.

Brokers, at times, pitch IPOs to individual investors when high-net-worth individuals or institutions shy away.

If an IPO is presented to you, approach it with skepticism.

Investing in IPO vs trading IPO CFDs

Investing in an IPO means purchasing and holding a company's shares. On the other hand, trading an IPO involves predicting share price movements using CFDs, allowing you to buy (go long) or sell (go short).

Why and How to Invest in IPO CFDs

Trading IPO stocks can present significant market opportunities. These initial public offerings garner considerable attention as investors seek the next standout stock.

Markets.com offers three methods to engage with IPO stocks: CFDs on fresh shares, grey markets for pre-IPO CFD trading, and the Renaissance Capital IPO ETF.

Markets.com consistently integrates new stocks, including those from recent IPOs. On their launch day, traders can actively trade CFDs on many of these IPO stocks.

A company's market cap is influenced by its share price. Before going public, it suggests a share price range, adjusting it based on market interest.

If you believe the company will be worth more than anticipated, you can trade long in the grey market; if you think it's overvalued, you can trade short.

Notably, our clients have had the opportunity to trade CFDs for companies like Lyft, Uber, and Aston Martin before their public debut using these grey markets.

Read up on this related article: What is a CFD?

Bottom line

An IPO is a transformative phase when a private company opens its shares to public investors. Beginning your journey in IPO investing requires a clear roadmap and a grasp of the marketplace.

Remember to consider the invaluable tips for IPO investment and understand the nuances between direct IPO investments and trading IPO CFDs.

“When considering initial public offering (IPO) for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.”