Recent high-profile consumer tech brand IPOs have brought this subject into the fore of the financially aware public.
As a result, I’ve received some recent questions from people I consider smart investors, so I thought I would revisit the topic.
An initial public offering, or IPO, is when a company decides to sell some ownership stake in itself in the form of common stock to the general investing public. Depending on the nature of the company and the size of the deal, an IPO event can generate a high level of media excitement.
When watching the IPO process unfold in the press, it’s important to understand, it is highly unlikely that the high-profile IPO is the first round of investment in most enterprises. Certainly, in the technology sector the company will have likely raised capital in the “garage” stage, where the company is merely an idea funded by the founder and people in the personal sphere of the founder.
Then as the company grows, it is likely the company at some point attracted venture capital, which is money from specialized funds or high net worth investors. After the venture stage, as the company matures, there may even have been a private equity stage, which is funded in a similar way, but also may involve institutional money from less aggressive investors such as investment banks or even pension funds.
After all these private funding stages, the now more mature company may choose to access the public markets, both to raise more capital from a wider net of investors and to bring some liquidity, aka the ability to sell, to earlier investors or stake holders in the newly minted publicly traded company stock.
In order to access the public markets, the company will typically engage an investment bank to prepare and structure the legal side of the company’s stock offering, and to line up future investors for the new stock as it comes to market. This process is called underwriting.
During this underwriting process, the investment bank may partner with other large investment firms to solicit interest in the offering and allocate shares to investors with existing relationships (typically the firms’ best institutional clients) with these firms. These IPO share allocations will be sold to investors at the IPO listing price, decided on by the company with guidance from the investment bank.
When the investors receiving allocated shares buy the shares directly from the investment bank assisting with the offering, the money invested goes to the actual issuing company or its earlier investors from the venture or private equity phases. After investors subscribe and buy the allocated shares, the shares will then list on a stock exchange and begin trading between investors. After this point when an investor buys stock in the company, the money goes to the selling investor and no longer to the actual company itself.
I’ve tried to simplify this process, but it’s clearly complicated. As an investor and adviser, I do find IPOs fascinating and exciting to observe, but not quite as compelling from an investment point of view.
I personally find it difficult to fully understand the forces of supply and demand impacting the early trading in a high-profile IPO. This is evidenced by the sometimes wild trading ranges experienced by newly listed stocks, especially some of the more recent issues.
While I am occasionally excited by the prospect of investing in companies going public, I have learned to take a measured and patient approach. While every investor needs to formulate their own strategy, I personally am likely to wait a few weeks, watching the stock’s established trading range before I jump into the pool. If this means I lose an opportunity here or there, I’ve learned to be OK with that form of missing out as well.