Investing in IPOs: Considerations, risks and what to know before buying stock in newly public companies

When a company you have heard about for years finally decides to go public, it’s natural to contemplate whether you should invest. Before you jump in, though, you’ll want to understand exactly how an initial public offering (IPO) works, what hurdles stand between you and obtaining those shares, and whether the company’s risk profile aligns with your goals.

For most individual investors, getting in at the headline offer price is harder than it sounds. Even if you do, IPO stocks can experience significant volatility. In this article, we’ll cover what you need to know about the steps, risks and alternatives for investing in IPOs.

How IPO investing works

An IPO is the process by which a private company sells shares to the public for the first time. Before an IPO, ownership is limited to a company’s founders, employees, and private investors. After a company becomes public, anyone with a brokerage account can buy shares on a stock exchange.

When investing in IPO stocks, it is important to understand that buying at the IPO price is not the same as buying after trading starts. The IPO price is the fixed price set by the company and its underwriters before the stock ever trades on an exchange. Once the stock begins trading publicly, the price shifts immediately based on supply and demand – sometimes dramatically.

For most individual investors, access to shares at the IPO price is limited. Underwriters typically distribute most of the initial shares to institutional buyers such as mutual funds, hedge funds and pension funds. Retail investors may be more likely to buy shares in the open market after trading begins. Your access also depends on which brokerage you use, what type of account you hold, and whether you meet any minimum asset or eligibility thresholds the broker requires.

Two ways to invest in IPOs

While many IPO shares go to institutional investors or high-net-worth clients, brokerages may be allotted shares to offer to their own clients. Even if you indicate interest in the IPO, however, getting an allocation of shares is not guaranteed. In fact, it is often quite hard to get IPO shares because some firms may restrict sales to those customers who meet minimum cash balances in their accounts, are active traders with the firm or possibly subscribe to “premium” account services.

Once an IPO begins trading on a public exchange, you can buy shares just like any other stock through your brokerage account. You place a market order or a limit order, and the trade settles on the standard settlement schedule. It is also important to remember that IPO stocks often don’t start trading at the opening bell on the New York Stock Exchange (NYSE) or Nasdaq; rather, there is typically a delay used to initiate trading at a stable price.

A “lockup” period of up to 180 days generally follows the IPO. During this time, company insiders – including employees and early venture capital backers – are usually restricted from selling their shares. When the window expires, additional shares may become available for sale, which can affect supply and demand and potentially influence stock prices.

Steps to take before investing in an IPO

If you’re thinking about investing in an IPO, you’ll want to do your research before moving forward. Here are some basic steps.

Evaluate the company

When a company goes public with its stock, it must file a registration statement with the Securities and Exchange Commission (SEC). The statement, which includes a prospectus, also covers the business model, management, financial condition and other relevant information investors need when considering an IPO.

Because the company going public will have had limited public financial history, it’s important for investors to consider a few key factors. These include the company’s revenue growth, expected growth trajectory, profit margins, and major competitors. Additional considerations might be how quickly the company is burning through cash and whether it relies too heavily on a small number of customers.

Assess the valuation

Compare valuation metrics like price-to-sales or enterprise-value-to-revenue ratios against similar public companies in the same sector. If the IPO valuation significantly exceeds industry peers without a clear justification in its growth story, that might be worth questioning. Remember, the company issuing the IPO is doing so to raise as much capital as possible, so its profitability, sales, competitors and growth potential are all critical factors in evaluating the IPO price as well as the company’s viability going forward.

Determine portfolio ‘fit’

Even if company fundamentals look solid, you’ll still want to think about how the stock may fit into your portfolio. IPOs tend to carry higher risk and volatility by nature; a newer public company may simply not have a track record long enough for you to make a confident long-term assessment. Be honest about your time horizon and risk tolerance: If the stock drops significantly in the months after the offering, does your portfolio have enough time to recover, and do you have the fortitude to take on that level of risk?

Understand who else is selling and when

Lastly, review the prospectus to determine whether shares are being sold primarily by the company, existing shareholders or a combination of both. Knowing that a significant portion of the offering comes from insiders or early investors, for example, can provide additional context about the transaction. Those shares don’t raise money for the company; rather, the proceeds from the sale of those shares go directly to the shareholders.

It’s also important to understand the lockup period, which temporarily restricts insiders and early investors from selling shares immediately after the IPO. Once the lockup expires, additional shares may enter the market, increasing supply and potentially affecting the stock price.

General process for investing in an IPO

If you’ve already done your research and want to move forward with investing in an IPO, here’s a simple overview of the process:

Alternatives to investing in an IPO

Investing in IPOs isn’t for everyone. If you are uncomfortable with the uncertainty that comes with newly public companies or just don’t like the idea of investing in an individual stock, IPO-focused ETFs or mutual funds may be a good option.

IPO-focused ETFs usually hold a mix of newly public companies or track indexes that include recent IPOs. Some mutual funds may also invest in companies before they go public or shortly thereafter, giving investors indirect exposure to IPOs. Mutual funds may cost more in fees than ETFs, but they can offer active management or a more targeted sector approach.

Another alternative is to invest in established industry competitors, which typically have longer track records. This move can potentially offer more price stability than an IPO while still giving you exposure to the same sector.

Finally, broad index investing may be another long-term strategy that could work for you. When measured by a broad-based index such as the S&P 500, the average annual total return of the stock market is about 10%. If you’re unsure about investing in a particular IPO, putting your money in index or sector ETFs may give you broader market exposure with less volatility risk.

The bottom line

IPOs can be exciting opportunities, but they come with real complexity and risk that can be easy to underestimate when hype is running high. For most individual investors, access to the offer price is quite limited and may not even be possible to obtain. Assessing the IPO can be difficult due to the absence of a long public track record. Volatility can be high as the IPO stock settles into a more stable price after the initial hype wears off and the lockup periods end. Anyone choosing to invest in an IPO should know how the stock fits with their overall investment goals, portfolio holdings, time horizon and risk tolerance.

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