IPO stocks: what they are and why you should care

How an Initial Public Offering (IPO) works

An Initial Public Offering (IPO) is a complex process that involves several steps. This process provides the company with the funds needed for growth and increases its visibility and credibility in the market.

IPO process steps

Let's break down the IPO process into clear steps:

1. Preparation and selection of underwriters

The company begins by preparing for the IPO, which involves internal steps like organising financial records, setting business goals, and ensuring basic compliance with industry regulations.

During this phase, they also select underwriters (usually investment banks) who will guide the company through the IPO process and help determine its valuation.

2. Due diligence and audits

Once underwriters are on board, external due diligence begins. Underwriters, along with auditors and legal teams, thoroughly review the company's financial statements, legal compliance, and risk factors.

This external audit ensures that the company is ready for regulatory approval and inspires confidence in potential investors before moving forward with the IPO.

3. Filing with regulatory authorities

Depending on the country where the company plans to go public, it must file the necessary documentation with relevant regulatory bodies. For instance, in the European Union, companies typically file with the European Securities and Markets Authority (ESMA) or other national financial authorities.

This documentation outlines key financial details, risks, and the intended use of the IPO proceeds. The regulatory process aims to improve transparency and help protect investors.

4. Marketing the IPO (roadshow)

Before the shares are listed on a stock exchange, the company and its underwriters perform a "roadshow," where they present the company's business model, growth potential, and financial outlook to institutional investors. This helps gauge investor interest and allows the underwriters to set the initial offering price.

5. Setting the IPO price

Based on the demand gathered during the roadshow, underwriters will finalise the IPO price. This price is crucial because it reflects what the market is willing to pay for the company's shares and directly influences the amount of capital the company will raise.

6. IPO allocation and listing

Once the price is set, shares are allocated to institutional investors, and the company's stock is listed on a public exchange, such as the London Stock Exchange, Euronext, or Nasdaq. The IPO date is set, and trading begins, allowing the general public to buy shares of the company.

7. Lock-up period

After the IPO, company insiders—such as founders, executives, and early investors—are typically restricted from selling their shares for a specific lock-up period, often 90 to 180 days. This is implemented to prevent market volatility by ensuring that there isn't a sudden flood of insider sales, which could negatively impact the stock price.

8. Post-IPO reporting and compliance

Following the IPO, the company must meet regular reporting obligations, including quarterly earnings reports and financial disclosures, and adhere to the governance and transparency requirements of the exchange on which it is listed. The company must maintain these standards to ensure continued investor confidence.

Why consider IPO investing?

IPO investing can be attractive for those looking to invest in newly listed companies. Here are the most important reasons why you might consider adding IPO stocks to your portfolio:

Potential for high returns

One of the main benefits of investing in IPO stocks is the potential for significant gains. Early investors could see substantial returns if a newly listed company performs well, but as always with markets, there are no guarantees your investment will succeed, and you may lose as well as gain money.

Opportunity to invest in innovative companies

IPOs often involve fast-growing companies that are leaders in their industries. These businesses might offer new technologies, products, or services that have the potential to disrupt markets. Investing in IPO stocks allows you to gain access to companies at the forefront of innovation.

Diversification of your portfolio

IPOs often come from various sectors, providing exposure to industries and trends that may not be well represented in your current portfolio holdings. Diversification helps mitigate risk, as the performance of different industries often varies in response to economic conditions.

Early access to new markets

Some IPOs give investors the opportunity to participate in emerging markets or industries that are just starting to develop. By investing early, you could potentially benefit from long-term trends as these markets grow, provided the company you invest in is able to capture this growth. This could be particularly relevant for sectors such as renewable energy, biotech, and fintech, which are experiencing rapid development.

Potential discounts at the offering price

IPO shares are often offered at a discount to generate interest and ensure the stock is fully subscribed. If demand for the shares is high, the stock may increase in value quickly after it begins trading, although corrections are also possible and some IPOs underperform their launch price. In some cases, investors who buy at the IPO price could benefit from price appreciation.

Some risks to consider with IPO investing

Newly listed companies usually experience high volatility, and their stock prices can fluctuate significantly in the early days of trading. Additionally, since these companies are newly public, there may be limited financial data available, making it more challenging to assess their actual value.

IPO investing is better suited for risk-tolerant investors who understand the potential for both high rewards and losses. Balancing IPO investments with more stable assets can help you manage the risks associated with this type of investment.

How to invest in IPOs

Investing in IPO stocks requires you to understand the process and plan ahead. Here are the main steps involved:

1. Research upcoming IPOs

The first step is to research companies that are planning to go public. Many financial websites and platforms offer IPO calendars that list upcoming IPO stocks. It's crucial to understand the company's business model, growth potential, and financial health before deciding to invest. Look for a solid track record, innovative products, and a clear plan for future growth.

2. Review the prospectus

Once you've identified a company that interests you, review the IPO prospectus. This document provides in-depth information about the company's financials, risks, and the purpose of the IPO. It helps you understand why the company is going public and how it intends to use the funds raised. The prospectus will also give you a sense of the company's competitive positioning.

2. Open an account with an eligible broker

Not all brokers have access to IPOs, so it's crucial to have an account with a bank or brokerage firm that participates in IPO offerings. Some firms only offer IPO shares to their high-net-worth clients, while others make them available to a broader range of investors. Be sure to check with your broker about any eligibility requirements or special conditions for IPO investing.

3. Submit your indication of interest (IOI)

Once you've chosen your IPO and have an account with an eligible broker, the next step is to submit an Indication of Interest (IOI). This is essentially a request to purchase shares in the IPO, but it does not guarantee that you will receive any shares.

The allocation of IPO shares is often limited, particularly for high-demand offerings, so there's no certainty that your order will be filled.

4. Place your order once the IPO is available

After the IPO pricing is finalised, you can place your order for shares. The price at which you buy may vary slightly from the initial IPO price, depending on market demand. In some cases, you may only be able to buy shares after they begin trading on the public market.

5. Monitor the stock after purchase

Once you've successfully purchased IPO shares, it's important to monitor the stock's performance, especially in the early days of trading. IPO stocks can be volatile, and their price movements can be influenced by factors such as initial investor demand, market sentiment, and broader economic trends.

Pre-IPO investing options

For those looking to invest in a company before it goes public, pre-IPO investing might be an option. This involves purchasing shares in a company before the IPO through private offerings.

Pre-IPO shares are typically reserved for institutional investors, venture capitalists, and high-net-worth individuals. However, in some cases, retail investors can also have access to these opportunities.

Conclusion: The role of IPO stocks in a strategic portfolio

IPO stocks can be an exciting addition to your portfolio, offering a chance to invest in companies at the start of their public market journey. However, while the stories behind these companies can be interesting, not all IPOs live up to the hype. As with any investment, understanding what you own—and why you own it—is essential.

Just like buying a house, the price you pay matters. And with IPOs, the early buzz can sometimes inflate your profit expectations. A good IPO is one where the company’s financial health and business fundamentals hold up even after the media attention fades.