Recently I’ve waded into the topic of riskier investments, like margin trading and penny stocks. What I hoped to accomplish in those posts was to discuss investment options that you might have heard of, and explain the risks. I’ve also cautioned against both for the FIRE investor, given that my belief is to remain true to the strategy of buy and hold. Nevertheless, it’s a worthwhile discussion because some investors, including early retirement investors, are more than willing to take on higher risks. It all depends on our nature – so what’s yours?
In today’s topic of higher risk investments, let’s discuss another type of investment that you’ve probably heard of – an IPO, or Initial Public Offering. IPOs pop up all over the news, especially when they’re for well-known companies.
IPOs are, simply put, when a company decides to sell shares of stock to the public. As you’re probably well aware, even the largest of companies started out much smaller than the conglomerates they became. To oversimplify it, smaller companies are more closely held, with the shares of stock owned by a smaller group of investors. As companies grow and decide they want (or need) more capital to expand, they look to other investors, including to the public stock markets. This is the very definition of why companies sell stock in the first place – to raise money for the business in exchange for equity in the company.
The IPO is the big introduction to the stock market, allowing investors to purchase shares of the company. Those shares entitle holders to a portion of the company’s profits – what we know as dividends. Shares also confer certain rights to participate in the company’s decision making. Certain classes of shares give holders the right to vote on corporate actions, including the election of its board members, who in turn select the corporation’s officers. And of course, once you own a share of a company’s stock, you have the ability to sell it.
So what’s the attraction to IPOs? Well, surely you’ve seen movies or tv shows with a rich character that talks about getting “in early” on some good IPOs and making their fortune. And if you haven’t seen any movies like that, you haven’t watched many movies from the mid to late 90s to the early 2000s, when having a character like that was popular. But, the basis for that character was not completely unfounded. Then, and now, there are people who make a great deal of money investing in IPOs by acquiring popular stocks at their IPO price and then either selling them off when they hit the open market and surge, or hanging on to them as they continue to grow.
Back in the olden days of trading, say the 1980s, 1990s, and 2000s, the ability to purchase IPO shares was fairly limited to high net worth individuals with a solid hookup. If you weren’t actually a founder of the company, you needed to know someone to be able to purchase IPO shares. And if you did, you could make quite a bit of money by essentially buying shares at what would later come to be seen at a steep discount from how the market valued the shares. So if we’re going back to the movie reference, this is what that rich character meant by “getting in on an IPO.” Nowadays, however, IPOs are more widely available, even to your average retail trader.
So how does an IPO happen? I’d say it’s quite simple because the process actually appears simple when you break it down, but in reality there’s quite a bit to it. Instead of getting into the details, let’s talk generally.
Basically, when you have a closely-held company that wants to expand, it might look to issue shares of stock. Now, you can’t just issue stock and start trading on the NASDAQ tomorrow. As we know, the stock market is heavily regulated. Publicly-traded companies are subject to a number of disclosure and reporting requirements, all of which they need to comply with before they can start issuing shares to the public. When a company is planning an IPO, they have lawyers who prepare mountains of required paperwork.
In addition to legal work, an IPO requires a determination of how many shares will be issued, the different classes of shares that will be made available, and, perhaps most importantly, a value for the IPO shares. For this, the company hires an investment banker, which, through the magic of financial modeling, develops what the market price of a given share should be.
As the paperwork gets ready, the IPO is advertised to investors. Way back when, this is when the select group of people were offered the opportunity to buy IPO shares. This of course still happens, but nowadays most brokerage firms are offered the ability to buy IPO shares, and they in turn allow individual investors to request to be “in on” the IPO. Even most online brokerages now participate in IPOs – check with yours to see if they do. Some still have a minimum net worth requirement before you can invest in IPOs, but others make them available to almost anyone with an account and some idle cash. Be aware that not everyone who requests IPO shares will get them, as brokerages have to allocate the shares to which they have access among the investors who’ve requested them.
Finally, close to the day the shares will appear on the stock exchange, the company and its investment bank will set the price and those who have been given the ability to acquire IPO shares will be able to make their purchase. The money comes in to the seller, and the shares are distributed to the purchasers. Shortly thereafter, the shares become eligible for trading on the open market. If you acquired IPO shares, you may be able to sell them on the open market at the prevailing market price. Once those shares hit the exchange, they’re now trading on the “secondary” market, meaning that traders are buying and selling them, but the company itself no longer receives any proceeds from the trades.
There are IPO issuances that have limitations on how quickly the holders can sell their shares. The restrictions may not necessarily come from the issuing company, but rather from the brokerage from which you bought them. Some will impose restrictions on your future ability to acquire IPO shares if you sell shares in the IPO you did acquire within a certain number of days after the company becomes public. Part of the logic behind this is that companies and brokerages don’t want people acquiring all these shares, putting them up for sale, and then dumping them on the open market at once. That would send the share price down, which doesn’t reflect well on the issuing company.
So, in the ideal world, for the investors anyway, you buy shares of an IPO, the price goes up, and you pocket the difference. This may happen in a short period of time or may be more long-term, but generally the thought is that you got in on the ground floor and your early investment will net you a solid gain.
And while this can and does happen, it’s not a given. IPO shares carry inherent risk; namely, the fact that when you purchase an IPO, there’s no history of how the company is viewed by traders and how the share price will move. All you have to go on are the lengthy disclosures, written heavily in legalese, provided to you before you handed over money for your IPO shares. You literally have no idea what the market’s perception of the stock is other than the calculations by the investment bankers.
There’s some real risk there, and you don’t have to research too long to find major IPO failures. The 2001 dot com bubble is a major example of IPO flops – and there are others that followed. Historically, we’ve seen companies that got in on the excitement of going public before the company had matured to a point where it was ready to do so, only to end in failure. After the dot com bubble, the IPO market actually stayed quiet for a while due to what happened.
But IPOs are far from over – after all, some companies truly are ready to enter the frenzy of being publicly traded. In the late 2010s and early 2020s, IPOs saw a resurgence in popularity, with a number coming to market. Coupled with the fact that they’re easier to get a piece of than ever before, it’s no wonder that retail traders have an interest in IPO investments.
For anyone interested in an IPO, check with your preferred broker. Many of the large ones have a process you have to go through before they’ll offer you IPO shares. And be forewarned, getting access to IPO shares may require a net worth minimum. If you’ve been investing toward FIRE for a few years or more, however, you might find that the minimums are not as high as you think they’d be.
But again, remember that IPOs can be risky. Also remember that if a company makes a good candidate for a strong IPO, the company will probably be a good investment later on as well. You may not be able to profit from a price surge if you don’t get in on the IPO, but solid companies are good candidates for buy and hold – which I still think is the best way to achieve FIRE. So a way of mitigating risk might be to let the stock hit the market, watch it for a while and see how it does, and if it appears to be a good prospect, buy it then. This is naturally subject to the risk of buying individual stocks generally.
There’s no doubt that some people have been able to retire early by an IPO investment or two, but that’s definitely a riskier path. And remember that, historically, most people who invested in IPOs already had significant means, such that their path to retirement was likely easier than someone working, saving, and investing. Plus, with the new spate of IPOs hitting the market in the early 2020s, there’s bound to be more risk. Companies are looking to make easy cash, which can spell risk for investors.
Like I always say, it comes down to your individual risk tolerance. IPOs are another investment option available to FIRE traders, but keep in mind the risk of investing in a single stock without any known history of trading on its new exchange.
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