An IPO is the practice of issuing shares of a previously private company onto public markets for the first time. There are few stocks that receive more hype on a day-to-day basis than a stock of a company that is scheduled to IPO soon. However, there are certainly some inherent risks embedded in buying this IPO price. In recent times, some of the most anticipated stocks have largely been in the technology, healthcare and biotech sectors. Think Alibaba (NYSE:BABA), Facebook (NASDAQ:FB) and most recently, Snapchat (NYSE:SNAP). But what makes these IPOs a risky buy for non-institutional investors has just as much to do with market mechanics as the actual business model and past profitability of the company.
When companies IPO, they issue a prospectus that details their 3-year historical financial statements and provides a background of the company’s operations, supply chain, customers, strategy and management. This prospectus, while providing adequate details to make an informed decision, may not be sufficient to determine the future trajectory of the company. As such, while IPOs are marketed as an opportunity to get in “on the ground floor”, a private investor may not have the resources necessary to stay updated about each potential development before it materializes. With the network of information and resources at their disposal, institutional investors are far more likely to react quicker to changes in market sentiment or updates from company management about the company. However, besides the business model risks, there are also ownership risks arising from early stage investors of the company seeking to make an exit. When a company IPOs, there is typically a “lock-up” period for existing shareholders wherein they have to hold their shares for a limited period of time before they can be sold. This is done to ensure no adverse volatility right on the first trading day of the company. However, these lock-up periods all coincide and end on the same day for the early stage investors, meaning that when the period ends, there is a rush to the exit as every investor looks to cash out their investment. What that means for the private investor is an uncomfortable amount of short term volatility.
Newly trading companies also present a valuation challenge. Typically, the primary valuations include the discounted cash flow, comparable companies and the precedent transactions analysis. However, for new IPOs, there isn’t enough historical information to make watertight assumptions and projections about its future cash flows. When conducting relative valuation techniques, there is generally a premium multiple attributed to larger, stable players compared to smaller players. For example, if a social media company was to conduct its IPO tomorrow, it likely wouldn’t trade at the same multiple that a Facebook (NASDAQ:FB) trades at primarily due to the network effects that a larger company enjoys. Each user on Facebook is worth incrementally more to advertisers than a user on other social media sites simply because those smaller players don’t have the stability and loyalty of a larger player. This means that as a private investor, you are faced with several valuation hurdles that handicap you from making a decision that would benefit your trading account.
From a market mechanics perspective as well, there are several obstacles to investing in IPOs. Typically brokers do not want to sell stock to retail investors for usage in “flipping” i.e. short-term speculative activities on the stock. However, institutional investors often do this as part of their daily trading activities. Therefore, while the private investor risks damaging broker relationships if buying into an IPO for flipping purposes, institutions are given a freer rein allowing them to conduct trading activities on the stock as they please (within legal parameters, of course). The recommendation for private investors to buy a recently IPO’d stock would then be to wait for the pullback (which could be caused from any of the reasons stated above like institutional trading, shareholder lock-ups ending etc.) and then getting in on the lower price once the company establishes a semblance of a track record in public markets.