Quick Answer: How Do You Invest in an IPO?

An IPO is the first public sale of a company’s stock. Individual investors may be able to buy IPO shares either through an eligible brokerage or on the public market after trading begins. However, access is often limited, and you may not be guaranteed shares. Additionally, given the nature of these sales, the initial stock price can be volatile.

What Is an IPO?

An IPO – short for initial public offering – is when a private company publicly sells its shares for the first time through a registered offering. Before an IPO, ownership of company stock is generally limited to founders, employees, and private investors such as venture capital firms.

Companies go public for multiple reasons, including raising additional capital, creating a liquidity event for founders and early investors, and boosting a company’s reputation and brand credibility.

IPO shares are sold on the primary market by underwriters on behalf of the company. After that initial listing, they usually trade on a stock exchange such as the Nasdaq or the New York Stock Exchange (NYSE). 

Access to IPO shares doesn’t guarantee a winning investment. An IPO can be an inherently volatile time for a company. According to the Securities and Exchange Commission, IPOs should be treated as speculative investments rather than sure things.

How IPOs Work

The process of preparing for an IPO begins long before the first public share of stock is actually sold. Many companies spend one to two years preparing for their IPO.

1. The Company Prepares to Go Public

During the early IPO process, a company will assemble its team of legal, financial, and underwriting professionals. It will tighten up its finances and financial reporting, do internal audits, and build up its internal processes to meet regulatory standards.

2. The Company Files a Prospectus

Before a company can sell shares publicly, it must register with the SEC. The process begins with the company filing its prospectus, which is an important document that includes a company’s:

• Business model
• Management team
• Financial statements
• Risk factors
• Use of proceeds
• Share structure and ownership
• Lockup terms
• IPO terms

The prospectus is part of the company’s S-1 filing, the comprehensive registration document it files before going public. The prospectus is designed to relay important information to investors and help them decide whether to buy stock. When you’re evaluating an IPO stock, the prospectus should be the core research document you refer to.

3. Underwriters Help Price and Distribute Shares

When a company decides to go public, it chooses an investment bank (or more than one) to serve as the underwriter for its IPO. The early job of the underwriters is to assess demand for the stock, set the IPO price, and distribute the IPO shares.

Institutional investors, which include mutual funds, pension funds, and hedge funds, are often major investors in IPOs and typically get priority over individual investors. Before the IPO, the underwriting banks will complete what’s known as a roadshow, which is when they meet with and present to key investors and get an idea of how much they can charge for the shares.

4. Shares Begin Public Trading

The IPO price, which is what early investors pay in the offering, isn’t always the same as what the shares first trade at in the public market. IPOs can be volatile, and prices often fall after the IPO. According to Nasdaq data, only about half of companies outperform the market in the first day after their IPO, and about two-thirds underperform the market after three years.

Most people who buy shares after a company IPOs aren’t actually buying IPO shares – they’re buying shares in a public secondary market that had been previously purchased, either before or during the IPO.

How to Invest in an IPO

Investing in an IPO isn’t as simple as logging into your brokerage account and placing a buy order. Here’s what you’ll need to know if you want to buy IPO shares.

Step 1: Check Whether Your Brokerage Offers IPO Access

Not every brokerage firm has access to IPO shares, and those that do often limit eligibility based on account type or size. To see if your brokerage offers IPO access, visit the company’s website and search for an IPO page. Top firms like Fidelity and Schwab offer IPO shares, but that doesn’t mean all customers will have access to them.

Step 2: Review the Preliminary Prospectus

Before investing in IPO shares from any company, read the prospectus. Pay special attention to risk factors, financials, and policies outlined in the document, as well as how the company plans to use the proceeds. For more help reviewing the prospectus, visit Schwab’s IPO due diligence checklist.

Step 3: Decide How Much to Request

Consider the maximum dollar amount you’re comfortable investing in the IPO shares. Factors to consider may include your risk tolerance, time horizon, liquidity needs, and tax consequences.

Generally speaking, an IPO should take up no more than 5%-10% of your investment portfolio. IPOs are inherently volatile, and even with a lower-risk stock, you take on some concentration risk by letting a single stock take up too much of your portfolio.

Step 4: Place an Indication of Interest or Conditional Order

Placing an order for IPO shares, sometimes called an indication of interest, is a request for shares, but it doesn’t guarantee you’ll get them. You may not receive IPO shares at all, or the final allocation may be smaller than what you requested. 

You may need to confirm your participation in the IPO after the final pricing. Review the final price compared to your expectations to make sure you’re still comfortable investing at the same level.

Step 5: Monitor the Stock After It Begins Trading

Once the shares begin trading, make sure to keep an eye on price movement in the early days and weeks. Pay attention to volume, which is the number of shares being bought and sold.

As time goes on, pay attention to company updates and earnings reports. These are likely to affect the stock price. Analyst coverage can also give you an idea of how the post-IPO period is going.

Finally, keep an eye on the stock value and its position size relative to the rest of your portfolio. IPOs usually include a lockup period, but once that expires, you may want to sell some of the shares to make sure you’re still comfortable with your asset allocation.

Can You Buy IPO Shares After the Company Goes Public?

Many interested investors don’t request shares directly as a part of the IPO. Instead, they wait and buy on the secondary public market once the company is public.

There are several benefits to waiting, including:

• More price discovery
• The ability to watch early trading
• More public information
• Less pressure from IPO hype

On the other hand, there are downsides. The price could rise before you get the chance to buy. Not only will you have to spend more to get your shares, but you’ll miss out on any early gains you could have earned. However, it’s impossible to know ahead of time how an IPO stock will perform, so each individual investor must decide for themselves what they’re comfortable with.

Pros of Investing in an IPO

Potential Early Access to a Newly Public Company

IPOs can offer you a chance to invest in a company before it enters the public markets, giving you a head start over other investors. However, IPOs don’t always perform as expected, so that early access won’t necessarily translate to outperformance.

Ability to Participate in Future Public-Market Growth

If the company’s stock performs well after its IPO, early shareholders will benefit from that growth, both in the initial days and in the long term. If the company sees major stock price growth in the early days, you would miss out on that growth by waiting to invest.

More Public Disclosure After Listing

Public companies are subject to more ongoing reporting requirements than private companies, giving investors more visibility into what’s going on behind the scenes. In addition to creating more transparency, this often affects the choices that companies make in the first place.

Liquidity Compared With Private Shares

Public shares are far more liquid than shares for private companies. When you want to sell some or all of your shares, you can easily do so in your brokerage account, often the same day.

Portfolio Exposure to New Companies or Sectors

Portfolio diversification is key, and an IPO can provide the opportunity to add new companies, sectors, or market caps to your portfolio.

Cons and Risks of Investing in an IPO

Limited Public Operating History

Companies that are newly or about to be public have limited public reporting compared to more established companies. While past performance doesn’t guarantee future performance, some investors may not feel as comfortable investing in a company without past quarterly reports to review.

Valuation Risk

Demand, scarcity, and media attention can push IPO prices above what the underlying fundamentals support. It’s easy for a company to become overvalued, only to have the stock price correct in the days or months following the IPO.

First-Day and Early Trading Volatility

IPO stocks aren’t a guaranteed home run. There’s often plenty of volatility in the early days and weeks, and you may find your shares quickly lose value, at least in the short term.

Allocation Limits for Individual Investors

Even if you want to invest in an IPO, individual investors often receive fewer shares than requested (or no shares at all), as most go to institutional investors.

Lockup Expiration Pressure

Company insiders and early investors are typically restricted from selling their shares for a set period after the IPO – often six months. Prices can drop as that lockup expiration date approaches, as investors anticipate the large number of shares that are about to go up for sale.

Hype and Emotional Decision-Making

There’s a lot of hype and media coverage around IPOs, which can lead to investors making emotional decisions rather than prudent financial ones. If you’re considering investing in an IPO, make sure to consult your financial advisor to make sure it’s the right choice for you.

IPOs vs. Direct Listings vs. SPACs

IPOs, direct listings, and SPACs are three different methods that companies use to sell shares on the public market. The three have different processes and benefits for companies.

IPO

An IPO is a registered public offering where companies work with underwriters (usually investment banks) to sell shares. It’s the traditional method for going public.

Direct Listing

A direct listing is another path that companies can use to enter the public market, usually by allowing its existing shareholders to publicly sell their shares. It’s more commonly used by large, consumer-facing companies, as it has lower administrative costs than an IPO.

SPAC

A special purpose acquisition company (SPAC) is a different route to the public market. The SPAC goes public as a shell company, and then merges with an existing private company. Through the process, the private company becomes public without going through an IPO. 

What to Look for Before Investing in an IPO

Investing in an IPO requires serious due diligence because of the associated risk. Here are some factors you should consider before investing.

Business Model

Has the company clearly explained in its prospectus how it makes money?

Revenue Growth and Profitability

Consider whether the company’s revenue is growing, whether its growth is accelerating or slowing, and whether it’s currently profitable. If the company isn’t profitable (which is the case for most IPO companies), does it have a clear path to profitability?

Use of Proceeds

How will the company use the money it raises in the IPO? Will it use it to fund further growth, repay debt, provide liquidity for existing shareholders, or something else altogether? More importantly, will the use of the proceeds help the company grow and boost its value?

Competitive Position

Where does the company stand in the market? Who are its direct and indirect competitors, and how does it protect its market position? This is more challenging for newer companies than those that are more established in their industry.

Customer Concentration

How concentrated is the company’s customer base? It can be risky for a company to depend on a small number of customers, even if they make a lot of money from those customers.

Debt and Cash Flow

Does the company have enough money to support plans while also managing its current debt? Are its current debt levels manageable? A company that’s overleveraged can be a red flag.

Valuation

What is the company’s valuation, and how does it compare with its public peers? Consider whether the company seems over- or under-valued based on its IPO price, and whether the IPO price already reflects aggressive future growth.

Insider Ownership and Lockups

Who are the company’s current owners, and when can those owners sell? Early investors are generally subject to lockup periods, but often sell off a portion of their shares when lockup periods end, which affects other investors.

Portfolio Fit

Does this investment fit your overall investment strategy? If it would create overconcentration in your portfolio, what’s your strategy to address that? 

Special Considerations for Employees of a Company Going Public

If you work at a company that’s been planning to go public, you may have been given the opportunity to buy company stock at a reduced price, either before or after the IPO. The question of whether to buy company stock requires different considerations than it does for other investors. Some questions to ask yourself include:

• At what price can I buy the stock, and how does that compare to the IPO stock?
• What are the tax implications of buying company stock?
• Am I subject to a lockup period, and for how long?
• What will the concentration of company stock in my portfolio be, and am I comfortable with that?
• Do I have the liquidity to make a large stock purchase with a lockup period?
• How will I further diversify my portfolio away from my employer’s stock?

Much of the question of whether to invest in your company’s IPO is based around taxes. It’s best to start considering your capital gains tax implications ahead of time, especially as it relates to your vesting schedule, when you’ll buy the shares, and when you plan to (or are allowed to) sell them.

Tax Considerations When Investing in IPOs

Investing in an IPO can have major tax implications, and making the wrong move can increase your tax burden. There are several things to consider and speak to your tax professional about.

Capital Gains After Selling IPO Shares

When you sell your IPO shares, you might pay capital gains based taxes on the type of account you held them in, how long you held them, whether you made or lost money on them, and your overall income situation. It’s important to do your capital gains tax planning before a major event, not after.

Short-Term vs. Long-Term Holding Periods

The amount of time you hold your IPO shares affects the amount you’ll pay in taxes. Shares you hold for one year or less are subject to short-term capital gains taxes, which have a higher tax burden. Meanwhile, if you’ve held your shares for more than a year, you could be eligible for a more favorable tax treatment. Make sure to consult a tax professional to verify how your shares will be treated for tax purposes.

What if the IPO Stock Falls?

If your IPO stock’s value falls, you’ll lose some of your principal investment, but you’ll also open up tax planning opportunities. You can use a strategy such as tax-loss harvesting to take advantage of your losses and help reduce your overall tax burden.

Alternatives to Buying IPO Shares Directly

Buying IPO shares isn’t the only way to benefit from a company going public. There are other (often less risky) ways to participate.

Buy After the Stock Starts Trading

Rather than buying IPO shares directly, you can wait until the stock is already trading publicly and buy your shares in the secondary market. This is ideal for investors who want more price discovery and public market information before committing.

Use Diversified Funds

Investors who want to avoid a concentrated stock position might opt for diversified funds that include the IPO shares. Mutual funds, index funds, and exchange-traded funds (ETFs) are an excellent way to gain exposure to many companies at once without allowing any one to have an outsize effect on your gains.

Focus on Long-Term Portfolio Design

One IPO shouldn’t drive your entire investment strategy. Think of it as one piece of a puzzle that could include many different individual stocks and diversified funds.

Common IPO Investing Mistakes to Avoid

IPO investing can be exciting, but it can also lead to emotional or impulsive mistakes on the part of investors. Here are some mistakes to avoid:

Chasing a First-Day Pop

Short-term price movement isn’t the same as long-term investment quality. Even if the price shoots up after the IPO, it doesn’t mean the company will have long-term success (and vice versa).

Ignoring the Prospectus

The prospectus is the most important information available when you’re making the decision to invest in IPO stock. Don’t make the mistake of ignoring the prospectus in favor of the media buzz.

Overconcentrating in One Company

If you decide to invest in an IPO company, it shouldn’t make up too large a portion of your portfolio. Invest an amount that’s appropriate based on your other holdings.

Forgetting About Taxes

Taxes are a key part of investing, and the last thing you want is to be surprised with a large tax bill. Your gains, losses, account type, and timing all make a difference in your tax liability.

Treating Media Attention as Due Diligence

There’s a lot of hype around some IPOs, but hype doesn’t replace due diligence and prudent investment management. Pay attention to the facts and your own financial situation.

IPO Investing Checklist

If you’re wondering if you should invest in an IPO, this checklist can serve as a final reference point to ensure you’ve done all of your due diligence and understand what you’re getting yourself into:

• I read the prospectus.
• I understand the business model.
• I reviewed the risk factors.
• I understand how IPO proceeds will be used.
• I compared valuation with public peers.
• I checked profitability and cash flow.
• I reviewed debt levels.
• I know the lockup expiration date.
• I understand that allocation is not guaranteed.
• I decided on a maximum position size.
• I considered tax consequences.
• I would still want to own the stock without media attention.
• The investment fits my written financial plan.

When an IPO May Make Sense

Investing in an IPO might make sense if you have clear investment goals with a time horizon you understand, and you know the IPO fits into those goals. It might also be right if you can tolerate the volatility and only invest a modest portion of your overall portfolio.

When an IPO May Not Make Sense

An IPO probably isn’t the right choice if you’re unfamiliar with IPO investing, but you’ve been swayed by recent media attention. It also likely doesn’t make sense if you’ll need the cash right away, you’re only investing because you think the stock price will skyrocket, or if doing so would leave you overconcentrated in a single stock.

Final Thoughts: Treat IPOs as Investments, Not Events

IPOs can be exciting, but excitement isn’t an investment strategy. Rather than buying into the hype around an IPO and envisioning it as a get-rich-quick scheme, ask yourself how it fits into your financial goals, risk tolerance, and time horizon. From there, make sure you understand the company you’re investing in and the tax implications, and that you’re prepared to take on the level of risk required.

If you’re wondering whether an IPO or a newly public company can fit into your investment plan, a financial advisor can help. Connect with a Wealth Enhancement advisor today to discuss your broader portfolio, tax strategy, and long-term goals, and whether IPO investing could be a good fit.

FAQs About Investing in IPOs

What is an IPO in simple terms?

An IPO is the first time a private company sells its shares in a public market. It’s a registered offering, meaning it requires the company to register with the SEC beforehand.

How do individual investors buy IPO shares?

It’s usually institutional investors that buy IPO shares, but individual investors can sometimes participate if they have an account through a brokerage firm that’s participating in the offering. Eligibility and allocation aren’t necessarily guaranteed for individual investors.

If you’re unable to purchase shares in the actual IPO, you can buy the company’s shares in your brokerage account once the IPO is complete.

Are IPOs risky?

Yes, IPOs are risky because they are new companies with a limited public track record, and they often lead to overvaluations that cause the stock price to later fall. The SEC recommends treating IPOs like speculative investments.

Do IPOs always go up on the first day?

No, IPO stock prices don’t always go up on the first day. On the contrary, many companies see their stock prices fall on or after the first day.

What is an IPO lockup period?

An IPO lockup period is a length of time that founders and early investors are prohibited from selling their shares after the IPO. It usually lasts about six months, at which point those individuals are allowed to sell.

Is it better to buy an IPO or wait?

Waiting until after the IPO allows you to see what happens to the price and volume immediately following the IPO, but it can also mean missing out on initial gains. It’s up to you and your financial advisor to determine whether an IPO is the right choice based on your risk tolerance, time horizon, and goals.

What should I read before investing in an IPO?

Before investing in an IPO, read the company’s prospectus, which includes key information about the company’s risk factors, finances, how it’ll use the proceeds, ownership structure, and more.

Can employees sell shares after their company goes public?

No, employees and other company insiders are often subject to lockup periods that prohibit them from selling their shares immediately after the IPO.

How much of my portfolio should I invest in an IPO?

There’s no universal answer to how much of your portfolio you should invest in an IPO, but most investors should limit a single IPO stock to about 5%-10% or less of their assets. The exact right number for you depends on your financial goals and risk tolerance.

Are IPOs better than index funds?

IPOs and index funds serve very different purposes in a portfolio. An IPO has more risk, but can be an opportunity for major growth. Index funds, on the other hand, carry less risk, but also don’t have the potential for as explosive growth.

Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor and affiliate of Wealth Enhancement Group.

This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor’s specific circumstances. Investing involves risk, including possible loss of principal.

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