IPO 101

Investing in growth companies

Companies that issue stock to the investing public for the first time do so using the Initial Public Offering (IPO). An IPO occurs when a private company sells an ownership position to the general investing public by issuing shares that trade on a major stock exchange. Going public is the common term. Over the last two years in the United States, an average of $35 billion in IPOs took place with 200 companies going public in each of those years.

Why does a company go public?

Companies issue stock to the public for many reasons including:

  • Needing growth capital for the business
  • Founding investors selling a portion of their original ownership
  • Paying off debt
  • Increasing exposure for the company
  • Improving company's ability to recruit upper management through stock options
  • Ability to issue further stock to facilitate takeovers using company stock

IPOs generally favor the brokerage firms that underwrite these issues and the companies that go public. A close second are institutional investors that buy the stock at its offering price and then sell it in the afternoon, profiting from the transaction. By pricing the shares below their real value, institutions are able to make a quick buck off unsuspecting individual investors. Unless you are a big institution, it's unlikely that you would be able to buy shares in an IPO even if you wanted to. Only those with the deepest pockets representing the widest interests get access to these opportunities. That's not such a bad thing for individual investors.

Sure, being in on the ground floor might mean a quick 15 to 20 percent return on your investment once it starts trading. However, studies have shown that many IPOs tend to trade below their offering price one year after going public. Investors might be better to focus on buying stocks that were IPOs a year earlier. Coca Cola went public in 1919 at $40 and was trading at $19 a year later. That is quite a difference.

IPOs do from time to time grow up to be extremely large companies and so, like any other investment vehicle, you should do careful research before investing. If it's a stock worth buying and holding for the long term, whether you buy it today or in a year is of little consequence in the end.

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