What is an IPO and how to make money on it?

Author: Forex Live | Category: Education

A closer look at IPOs

What is an IPO?

IPO stands for Initial Public Offering, which means primary placement of stocks in an exchange, after which any individual or institutional investor can buy them in the open market. This way the company becomes public. An IPO entails certain expenses, however, if it goes smoothly, the company gets a chance to attract billions.

You can find detailed information on how to make money on IPO in this article. But in this post, we will focus on the very concept of IPO and how it works.

An IPO gives the company certain opportunities that it has to correspond to. The transition period may take from several months to a year: the company has to give transparent financial reports for several years and boast a good business history. The stages of the IPO are as follows.

Preliminary stage

At the preliminary stage, the management decides whether it is profitable for the company to become public at all. Experts evaluate the business, corporate management, and the structure of assets. Then they calculate at what price and in what volume the placement will be carried out, thus defining future capitalization.

Also, they evaluate the informational and financial transparency of the company: it needs to be transparent to increase potential investors' trust and augment reputation. Financial departments of the company get prepared for public quarterly reports that the issuer must provide to all trade participants. The main goal of an IPO are:

  • To attract investor capital from all over the world;
  • Market evaluation of the business as a means of protection from undesired merging;
  • Media popularity, which increases investor trust and decreases potential expenses on attraction of loaned capital (bank loans, % of corporate bonds);
  • To make the stocks of the company a liquid instrument suitable for paying for merging trades. For example, Facebook partially payed in stocks when buying WhatsApp;
  • To let the founder of the project or a group of investors to buy stocks fully or partially;
  • To give the employees an opportunity to buy the stocks of their own company or get options for sale as bonuses;
  • To use the stocks as security interest when attracting loans;
  • If the company management decides to carry out an IPO for any of the above-mentioned reasons, the next stage begins.

Preparatory stage

From here, the very process of the IPO begins, carried out by the underwriter. An underwriter is normally a large investment bank (Goldman Sachs or Morgan Stanley), which the management negotiates with on the issues of the stock price, volume of placement, broker, and the platform. The underwriter may also buy the stocks of the company, even at a lower price than announced at the IPO, thus making money on future preliminary sales. In case the company is working in a promising area (technology, healthcare, consumer goods), investment banks may show a serious competition over the right to be the underwriter.

Next, the underwriter prepares an investment memorandum sent to the regulator - the commission on securities and stock market (SEC in the USA). In the report, they present the whole structure of the owners, reports, and give the reasons for the company's decision to carry out an IPO. In case the regulator considers the application to comply with all the requirements, it sets the date of the IPO.

Then advertising called the Road Show begins, meant for maximally increasing the interest of potential investors towards the securities of the company. The top management of the company organizes a series of meetings with the largest brokers and investors in the word financial centers: London, New York, Hong Kong, or Tokyo. The Road Show usually takes about two or three weeks. The underwrite collects applications for the IPO, evaluating how many stocks and at what price potential investors are ready to buy.

Final stage

Listing is the moment when the stocks start trading at the exchange as the result of the work of the underwriter and the company described above. Only at this stage we can evaluate the success of the IPO. If on all the stages the company was decently assessed, and thus the market price became adequate, the issuer acquires stable reputation and a long-term uptrend in its stocks.

What are the disadvantages?

As everything in the world, an IPO has both positive and negative sides, otherwise large companies, such as Levi Strauss (LEVI) would not wait for so long to decide on one.

Firstly, a public company is always scrutinized by all controlling institution. The government and the platform itself poses a whole range of requirements that the company is now obliged to comply with. Sometimes lagging with their fulfillment decreases significantly the positive effect of the IPO.

Secondly, the founders of the company get tied up with the lock-up period, which means they may not sell all of their stocks right after the IPO. As a rule, it lasts for three to six months. If the market situation is negative, as recently, in the times of COVID-19, this limitation may impose losses on those who are in a real need to sell their stocks as soon as possible.

Thirdly, in the US, every stockholder is protected by the corresponding legislation, and the SEC keeps a close eye on all violations. By the norms of the regulator, any investor, even with a tiny number of stocks in the portfolio, may take the company to court if they consider that the company violates their rights as a stockholder. Knowing the peculiarities of the US judicial service, we can only imagine the expenses of the company. For certain businesses, the very opportunity of legal arguments with their stockholders is unacceptable.

How much money do issuers make?

  • In 2008, VISA hurried to carry out an IPO, earning 17.9 billion USD;
  • In 2010, General Motors attracted 23 billion USD;
  • The same year, AmerisourceBergen Corporation attracted 22.1 billion USD;
  • Twitter, so highly appreciated by President Donald Trump, gathered 14.5 billion USD in 2013;
  • Google carried out an IPO in 2004 and earned 1.6 billion USD;
  • Facebook that we have already mentioned attracted 16 billion USD in 2012; its placement stock price was 38 USD but on August 21st, 2020 each stock cost 267 USD (+702%).

The largest IPOs of 2019

1. Uber

This taxi service was founded in 2009 and is working in 60 countries already; nonetheless, the company has remained losing for the whole of 11 years. On May 10th, 2019 the company carried out an IPO, selling 180 million stocks at the price of 45 USD and attracting 8.1 billion USD. As you see on the chart, investors are still losing because the lock-up period did not allow them to sell the stocks ata price higher than 45 USD.

2. Avantor

Avantor produces materials and equipment for biomedical research. Among the goods it sells are incubators, test tubes, analytical gadgets, protective clothes, automatic droppers, orbital shakers, evaporators, and materials for critical environments. The company owns 27 plants.

Among other assets, the company owns the VWR company with 1.2 million medical goods. In 2018, the net loss of Avantor amounted to 87 million USD. Avantor planned to attract 3.7 billion USD, selling its stocks at the price of 21 USD each. At the IPO, the stocks were sold for 14 USD each, and in the end Avantor earned 2.9 billion USD.

On the chart you see, that the price is still in the profitable area, so investors have also made some money. Keeping in mind how promising this sector is, the stocks will go on growing.

3. Lyft

Lyft is the main rival of Uber in the USA. On March 29th, the service carried out an IPO. This was the first IPO of a large tech company in 2019. It cheered investors up a lot: in the first 15 minutes, 19 million of stocks were sold; the stock price at the placement leaped up by 20%. The market capitalization of Lyft after the IPO amounted to 25 billion USD. The company attracted 2.3 billion USD, selling the stocks at 72 USD each. However, the cheerful moods soon ended, and by the end of the lock-up period, the stocks dropped by 43%.

4. Pinterest

This photo service was launched in 2010. In 2018, its losses amounted to 63 million USD, while its profit grew by 60%. The IPO of Pinterest became the largest IPO of US social networks after the IPO of Snap in 2017. The photohosting is used by 250 million people monthly, which is comparable to Twitter used by 320 million people every month. During the IPO, Pinterest was evaluated as 12.7 billion USD. The stock price at the IPO was 19 USD. As a result, the company collected 1.4 billion USD, and its market capitalization reached 10 billion USD. Now its stock price is 33.90 USD: the investors and underwriters must be happy.

5. Beyond Meat

Beyond Meat is the world largest producer of vegan meat alternatives. The company was founded in 2009 in Los Angeles. The product line includes foods flavored and textured like chicken, pork, and beef. The company is traded in NASDAQ under the ticker BYND. Its IPO happened on May 1st, 2019 at the price of 25 USD per stock. The company only attracted 240 million USD. Note that after the lock-up period it brought its investors 620% of profit.

Mind that the price has never yet declined below the placement price.

Bottom line

Investing in IPOs is highly risky. Even companies with the brightest PR sometimes end the lock-up period with a loss. The stocks may be used for active trading and short-term investments after the start of trades.

This article was submitted by Dmitriy Gurkovskiy, Financial Expert and Author at RoboForex Blog
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