- What is IPO
- Goals of IPO
- Advantages of IPO
- Drawbacks of IPO
- Types of IPO
- Types of contracts between the issuer and the underwriter
- Direct listing
- Risks of direct listing
- Road Show
- How to make money on IPO
What is IPO
IPO stands for Initial Public Offering of the stocks of the issuing company on the stock market. In other words, through the IPO companies enter the capital market, where anybody can become their investor upon buying their stocks. An IPO can be carried out by additional issuing of stocks or by selling the stocks already at hand.
Goals of IPO
Attracting new funds to the company has always been considered the main goal of IPO; however, sometimes the latter is carried out by the issuers that do not need additional funds. In this case the IPO is meant for the existing investors to get money. The stockholders could sell on the secondary market as well, but that would require compromise with the buyers upon the optimal price. Conversely, selling the stocks on the market allows to set the market price of the stocks, increase their liquidity; if the issuer does not need additional funds, the stock price is usually higher than on the secondary market.
Advantages of IPO
IPO also helps attract high-class professionals to the company, which is essential for its development; what is more, the issuer gets an opportunity to reward its leading experts by options, increasing the motivation. Publicity implies unveiling all information about the company, so it may be said that IPO enhances investor trust.
Another important fact is that the issuer can use its stocks as a means of payment in case of a takeover or merging with another company; it can also issue additional stocks. All in all, as long as the company is interesting to investors, it can virtually “print money” and attract funds for its needs without taking loans that must be paid back.
Another advantage of IPO is the availability of unlimited funds, which the company can attract and use for its development.
Drawbacks of IPO
Any medal has its other side. In our case an IPO entails a commitment to reveal full information about the company. What is more, if during the IPO there were more than 50% of stocks thrown into the market, the initial owners risk losing control over the issuer. New expenses appear, such as those entailed by providing information about the company’s activity to regulatory authorities and the investors, or by the procedure of the IPO itself; and in case of a failure all the expenses are to be paid by the issuer solely. In perspective, a decline in the stock price may lead to filing class action suits by the investors that may accuse the management of providing false information or misinterpreting the existing information. The market reality sometimes makes even the stocks of successful companies fall in price just because the stock exchange indices decline; as a result, the stock price is not always in compliance with the current position of the company on the market.
Types of IPO
There are two ways of entering the market. The first implies attraction of agent services; the company signs a contract with an underwriter that will be preparing the IPO. The second way is direct listing which means that the company prepares the IPO on its own. Which way to choose is for the issuer to decide.
Direct listing is not very popular because it entails certain risks for the current stockholders, and because new stocks are not issued during direct listing. In this case the company sells the stocks that already exist.
First, let us have a look at traditional IPO, i.e. the one carried out with the help of underwriters.
Underwriting on the stock market is a service of stock emission and public placement on the market, provided by financial organizations. Such organizations are called underwriters; most often they are banks and insurance companies.
Types of contracts between the issuer and the underwriter
Preparing for an IPO, the company has to decide, who it will hire as an underwriter, and what type of contract they will sign.
There are two types of contracts:
- The first one is called Firm Commitment. The underwriter assumes all risks connected with the IPO. The company sells its stocks to the underwriter at an underestimated price, gets its money and watches the IPO. The underwriter’s task is to sell the stocks on the market at a price as high as possible and to make profit. In case of a failure the one that suffers losses will be the underwriter because the company has already received its money.
- The second type of contract is called Best Efforts. In this case the issuer places a certain amount of stocks on the market, and the success depends on whether investors will buy them or not; if the demand turns out low, the price will start falling, and the company will fail to attract the expected sum. The IPO will be called a failure, and the placement fee will eat up most of the funds raised by the selling of the stocks. The underwriter has no responsibility for the amount of stocks sold on the market.
In order to choose which stocks to by on an IPO, an investor should look at the companies’ underwriters.
If the company is famous and competitive, underwriters may fight over the right to place its stocks on the market. In this case the issuer will pick up the biggest and the most popular underwriter, such as Morgan Stanley, Citigroup, Goldman Sachs and other banks. One company can have several underwriters. If an unknown company enters the market, naturally, it cannot afford the services of major underwriters, so the choice is going to be much more modest; the risk of a failure will be much higher then, as the investor interest might be minimal.
In case of the traditional way to enter the market, the issuer hires professionals that apply themselves to preparing papers and advertising, attract investors, while the issuer has to pay for expert services and watch the trading. Direct listing means that the company does all preparations itself. The expenses will be 3-4 times less, but the preparation may take longer. After selling the stocks on the market the company receives same advantages as after the traditional placement. The difference is that the company does not issue new stocks, hence, does not attract funds.
Risks of direct listing
One of the main aims of IPO is attracting public funds, which does not happen in case of direct listing. Then a question emerges: why does a company that does not need additional funds undergo an IPO?
After the crisis of 2008 the governments of the leading countries began the policy of Quantitative easing; this led to an increase in the volume of money in circulation on the market; the amount of investor money grew accordingly. Thus, it is hard for the companies to attract private funds for the development, and there is little reason for IPO.
For example, Slack Technology (NYSE: WORK) that entered the market via direct listing in June 2019, had around 900 million USD of free funds and was in no acute need of money. Here the aim was to enhance the liquidity of the stocks and sell them at the market price, in accordance with the stockholders’ wish; as long as the company was financially stable, it did not fear the risks of direct listing, that are definitely present.
First, during direct listing there is no Lockup period, which means the investors have the right to sell the stocks on the first day of trading. Lockup period is set by the company for 90 to 180 days in order for the investors not to lower the stock price by selling.
In case of a standard IPO the investors can buy the stocks before the IPO with a discount. Setting a Lockup period, the company makes sure that unscrupulous investors will not buy a whole bunch of stocks before the IPO and sell them immediately, provoking a serious decline in price and a failure of the IPO.
Another risk is the growth of the volatility, because the interest of investors is tested right on the market. In case of a normal IPO the underwriter studies the interest to the company beforehand and forms the stock price accordingly; in case of a direct listing the price is formed on the basis of the information about bargains on the secondary market. What is more, the underwriter acts as a buyer of the stocks if the price starts declining. Their actions are clearly visible on the chart as a support on a certain level, restoring the demand and the stock price.
Sure, there are exclusions. Such was the IPO of Facebook: the pressure upon the stocks was so strong that the underwriter ran out of resources, and the stock price decreased by 50% against the initial IPO price.
Though direct listing is not totally uncommon, it is not common either. So, one of the main ways to make profit on the IPO for ordinary traders is the growth of stock prices, because in case of traditional IPO there is a Lockup period set, and no chance of making profit on the decline of the price. Conversely, direct listing is chosen by strong companies, so it may be risky to sell their stocks.
There are two ways of making profit on the stock price growth:
- The first and the easiest way is to buy the stocks on the day of the IPO, no matter which type of IPO the company has chosen.
- The second way implies buying during the Road Show, i.e. the period of preparation for the IPO when the underwriter is active.
A Road Show means a series of meetings with potential investors and analysts in the countries with developed stock markets. The underwriter advertises the issuer through prepared presentations, speaks about the issuer’s financial state and the perspectives for development. On top of this, the underwriter involves mass media in advertising, attracting as much attention as possible, hoping for the investors to get interested and the analysts to give good recommendations.
How to make money on IPO
During the Road Show investors are offered the stocks at a discounted price, which looks tempting, especially if the company is a large one. An ordinary trader, having 10-50 thousand USD on their account, cannot afford to buy stocks directly from the underwriter as the latter works with the investors owning more than 1 million USD on their accounts. That is why there exist agent companies that accumulate the applications of investors, willing to by the stocks of a company through IPO, and then make an application to the underwriter under their own name. However, this is just in theory, because in practice the underwriter does not always fulfill such applications, selling, say, 70% of the demanded 100 thousand stocks.
That is why the first way of earning on the IPO is to buy the stocks before the offer.
If for some reason you did not manage to buy the stocks before the placement, or you did not want to do so because of the Lockup period, you can always do it the day of the IPO.
During the last week of June 7 issuers carried out IPO on the NASDAQ, and only 2 of them closed the session with a loss on the first day of trading; the stocks of 1 company stopped at the opening level, while the stocks of the remaining 4 issuers return on equity profit from 0.5% to 35%.
Thus even a “blind” purchase of stocks may bring you profit on the day of IPO; however, it is still desirable to analyze the open sources of information about the company. Particularly important is the underwriter of the issuer: the larger and more famous the underwriter is, the higher is the probability of a successful IPO. The amount of net profit is also important: it is not uncommon that even large companies enter the market without net profit and do not pay dividends; their only source of income is the growth of the stock price, which may hinder investor interest towards the company. Next, the amount of stocks planned for the placement can influence the success of the IPO; too big number of stocks offered can decrease their price on the first day of trading. The amount of stocks should be comparable with the number of stocks of similar companies already on the market in the same segment.
So, the second way of making profit on IPO is buying stocks on the day of IPO.
The investors that have bought the stocks during the Road Show cannot sell them during the IPO; so, they become mid-term investors obliged to keep the stocks in their portfolios for several months. The underwriter works with the investors who have more than 1 million USD invested and, hence, may be called experienced market players; if they buy certain stocks regardless of the Lockup period, it would be wise of ordinary investors to consider purchasing the stocks of the same company and keeping them in their portfolio for several months. Of course, it is still necessary to analyze the information about the issuer: its underwriter, its financial state and perspectives. The indirect indicator that is the easiest to analyze is the starting price of IPO.
For example, 23 companies carried out IPO in May; only 8 of them are showing negative return on equity, with only one company out of those 8 having the IPO price more than 20 USD.
|Company||IPO price (USD)||Evaluation (million USD)||Return on equity (%)|
|Red River Bancshares Inc (RRBI)||45.00||27.0||-12|
|Uber Technologies Inc (UBER)||45.00||8100.0||+4,7|
|Parsons Corp (PSN)||27.00||500.0||+26|
|Beyond Meat Inc (BYND)||25.00||218.8||+371|
|Axcella Health Inc (AXLA)||20.00||71.4||+48|
|South Plains Financial Inc (SPFI)||17.50||59.2||0|
|Cortexyme Inc (CRTX)||17.00||75.0||+105|
|Mayville Engineering Co Inc (MEC)||17.00||106.3||-14|
|Luckin Coffee (LK)||17.00||510.0||-26|
|TransMedics Group Inc (TMDX)||16.00||91.0||+27|
|Sciplay Corp (SCPL)||16.00||352.0||-28|
|Fastly Inc (FSLY)||16.00||180.0||0|
|NextCure Inc (NXTC)||15.00||75.0||+8|
|Milestone Pharmaceuticals Inc (MIST)||15.00||75.0||+25|
|Avantor Inc (AVTR)||14.00||2900.0||+24|
|Bicycle Therapeutics Ltd (BCYC)||14.00||60.7||-40|
|So-Young International Inc (SY)||13.80||179.4||0|
|Yunji Inc (YJ)||11.00||148.5||-23|
|Sonim Technologies Inc (SONM)||11.00||39.3||+14|
|Trevi Therapeutics Inc (TRVI)||10.00||46.7||-20|
|Trevi Therapeutics Inc (TRVI)||10.00||40.0||+14|
|Ideaya Biosciences Inc (IDYA)||10.00||50.0||-41|
|Rattler Midstream LP (RTLR)||10.00||333.3||+11|
|TOTAL return on equity||+474|
So, having bought stocks in May at the IPO price over 20 USD, one could make profit of 437.7% on the return on equity.
Of course, there are such companies as Beyond Meat Inc (BYND) which stocks yield colossal profit; however, this is just a nice compliment to those who use IPO for making money.
Last year a Canadian company Tilray (NASDAQ: TLRY) demonstrated an even higher return on equity. In a month’s time the price of its stocks grew from 23 USD to 300 USD, yielding more than 1,200% of return.
IPO provides individual investors with an opportunity to participate in the future of a company and make profit on it. Everything depends on the right choice of a company: when it is done, the investor only has to decide upon the type and the period of investment. According the to statistics, companies that hire famous underwriters, have good perspectives of development, demonstrate encouraging financial results and set a high IPO price, will most probably yield positive return on equity. In some cases investments yield superprofit, but it is available only to those stockholders that take part in the IPO.