At some point, your friendly local stockbroker may present you with the opportunity to invest in an IPO (initial public offering).
(In an IPO, a company raises capital by selling shares to investors. When you buy a stock in the secondary market, you're buying it from another investor. In an IPO, the cash you pay goes to the company.)
You've probably heard about the IPOs that see a surge in the share price on the first day of trading [like Alibaba (NYSE:BABA), when its shares jumped by 36 percent on the first day of trading when the company went public in September 2014]. But that happens rarely - and should not be a reason to invest in an IPO.
Some big IPO action
So far this year, there have been 772 initial public offerings. That's the most since 2007. These offerings have raised a total of US$83.4 billion, which is up 90 percent from the same period last year.
And the Asia-Pacific region is leading the charge. There have been 468 IPOs in this region (with US$37 billion raised) this year.
Meanwhile, the second half of 2017 will see some big offerings. Two Chinese companies, China Tower Corp. and Sinopec Marketing Co. Ltd., each hope to raise US$10 billion later this year. And later this month, Singapore will see its largest IPO since 2013, when NetLink Trust aims to raise close to US$2 billion.
Before you buy into an IPO…
So if you're looking at IPOs, it pays to ask these seven questions first.
1. Who gets the money?
The whole point of an IPO is to raise money from investors. The thing is, who gets the cash?
Sometimes the founding shareholders (who are usually the management) of a company receive some, or even all, of the proceeds of a share offering. If so, the key question is this: Why are they selling? After all, these insiders know better than anyone the real prospects of the company. And if they're selling, what does it say about the company's prospects? Nothing good.
Of course, that's not entirely fair. The founding shareholders of a company may be looking to take some money off the table, after investing years and funds into building the business. They may want to diversify their portfolio of assets - and maybe buy a yacht.
However, from the perspective of a future shareholder (that is, the buyer of shares in an IPO), it's much more encouraging if the proceeds of an offering are to be invested in the further development and expansion of the company, than if current shareholders are cashing out. And in any case, the founding shareholders should be holding on to a significant stake in the company, so that they continue to have skin in the game.
2. Why now?
A company may be selling shares to raise capital because it needs funding to grow - or company insiders who are selling may believe that the environment for selling shares is at a point of maximum optimism, in which case they'll get a better price (from a valuation perspective) than they would otherwise. Like everyone else, the people who are selling want to "sell high". And investors buying into an IPO are betting that the company's growth prospects are still strong.
Who knows best? The danger of being wrong is that you buy an offering when the company is hitting all cylinders, and things can't get any better… in which case, they can only get worse.
3. Is the company profitable?
If it isn't, let's face it: You're not investing - you're speculating. That doesn't mean you shouldn't buy the IPO, but it does suggest that the risk associated with the offering is higher. And you should account for that higher level of risk accordingly.
4. Are the shares expensive or cheap?
The shareholders who are selling will want to sell at as high a valuation level (that is, on a price-to-earnings basis, for example) as they can. Investors buying into the IPO, meanwhile, will want a low valuation so that there's room for the share price to rise.
The big question - as with any valuation exercise - is what the stock is being compared to. The people selling the IPO (that is, the bankers for the company) will focus on comparables that trade at high valuations - so that the shares they are selling will appear cheap by comparison. The shares of companies that are direct competitors in the same country and sector, with a similar growth rate, to the company that is going public are generally the best comparables.
Even then, the company hoping to sell shares will weave a story to explain why their shares should be more highly valued. If you believe it, then the shares will have less room to rise before they trade at a premium to comparables. And that means you have less upside to your investment.
5. Can I get shares if I want to?
To get shares in an IPO, your broker has to be part of the IPO, or else have a relationship with the banks that are. And most brokers tend to save their IPO allocations (at least those for which demand is greater than supply) for their "favored clients" - customers who trade with large sums of money.
So underwriters and "big investors" tend to have the first bite… and individual investors are often left with the crumbs from the table, or with the shares of a dud offering. To paraphrase Groucho Marx, would you want to buy shares of a company that has shares available to sell to you?
6. What about fees?
Not long ago, investment banks made a killing on initial public offerings. They could earn around 7 percent of total proceeds, though that could vary according to the size of the deal. In effect, that meant investors were only getting 93 cents of value for every dollar that they invested in a deal.
Thankfully (for investors), that's all in the past. Today, fees charged by investment banks are a lot more reasonable… closer to between 3 and 5 percent. So this isn't really a factor from an investment perspective. But do bear in mind that your broker will stand to make a lot more by selling you an IPO than by just selling you a stock that's already trading.
7. What rights will you have as a shareholder?
Traditionally when companies issue equity to shareholders, those shares come with voting rights. "One share, one vote" used to be the conventional wisdom underpinning corporate governance. But that is now changing, especially in the technology space.
Google (NASDAQ:GOOG) (NASDAQ:GOOGL) (now known as Alphabet Inc.) led the charge in 2004 for what has become a common practice in technology IPOs of issuing dual-class shares. For example, with Google, they issued Class A common stock for new investors with one vote per share. But founders retained Class B common stock which carried ten times the number of votes per share.
Likewise, Facebook (NASDAQ:FB) did something similar. But the most egregious recent example of this kind of voting structure occurred earlier this year with the Snap Inc. IPO. In that case, new investors bought shares with absolutely no voting rights whatsoever. In fact, because of the way the IPO was structured, nearly 90 percent of control is retained by the 27-year old founders.
As an investor, you need to ask yourself if you are comfortable with companies taking investor money, but not giving investors any say in how the company is run at all.
If you're looking at investing in an IPO, get answers to these questions first. And if it sounds too good… it probably isn't true.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.