The life of a stock is an eventful one, and it all starts at its IPO. Let’s take a deeper look as we step closer towards achieving financial fluency.
What is an IPO?
An IPO is an acronym for initial public offering. This represents a company’s first sale of stock to public investors. For instance, Uber has raised private capital; hence, you cannot find Uber stock on the Rapunzl platform (or any stock market for that matter). Before an IPO occurs, ownership of a company is held by individuals that are generally founders, their families, and venture capitalists who specialize in investing in private companies.
Private companies require a lot more research and due diligence when investing because they do not have to adhere to the same regulations of publicly traded companies. They are able to keep their finances private; they do not have to disclose their financial statements to outside investors. Less financial reporting means less auditing. This allows private companies to stay leaner, and hire based on what will grow the company rather than appease security laws.
After an IPO, when a company is public, this all changes.
Going Private to Public through an IPO
If a company wants their stock to be traded on a market such as the New York Stock Exchange or the NASDAQ, they have to file numerous reports with the SEC. These filings essentially prove that the company is worthy of investment. Now, without diving into the regulations of the stock market, we can at least dissect the benefits of going public. The advantage of an IPO is that company a can raise large amounts of capital to expand their business. Furthermore, this capital no longer has to come from high net-worth individuals and private equity funds but can come from any investor.
Examples of recent IPOs are all around us. When Facebook went public in 2012, they were able to sell stock and raise $16.01 billion to accelerate growth. Alibaba (BABA), which launched at a near $168 billion valuation, set their IPO price at $68 a share. Within 2 months, shares had shot up 63%.
Downside of IPOs
As mentioned earlier, when a company goes public there is full transparency: the company discloses all of its financials and places itself under a massive amount of scrutiny. If the company engages in questionable behavior that harms the environment – investors will know and react. If the company discriminates in hiring practices, investors will punish the company by selling its stock. Even inappropriate office culture (think Wolf of Wall Street) can have an adverse effect on company perception.
Another potential downside of becoming publicly traded is the possibility of large institutional investors (think managers of public pension funds/university endowments) purchasing mass quantities of stock in a company. On one hand, this provides liquidity and scale to the business. Founders can sell some of their equity. Venture capital firms who prefer investing in smaller firms can sell their stake. On the other hand, the institutional investor will likely have a greater ownership stake in the company. Nothing is free, particularly in investing. This institutional ownership stake allows large investors to have a voice on the company board and dictate operations to a greater extent.
Since these institutional investors own a larger piece of the company, they can dictate how it is run, how people are compensated, where to expend capital, and who to fire or hire. Whereas, if a company is privately held, it is more likely that individuals with shares will be thinking on their behalf as opposed to the behalf of pension holders/universities who will have different beliefs/interests.
Bottom Line: IPOs are Volatile
In 2016, IPO stocks, in aggregate, were up 12% in contrast to All Ordinaries Index (XAO) (essentially capturing all other stocks), which was only up 7%. But like any investment, past performance is not indicative of future results. This year has been tumultuous to say it kindly. Snapchat (SNAP) is down 20% from its IPO after a 28% decline in the first 3 weeks of public trading.
Twilio (TWLO) is another phenomenal example of IPO volatility. The company went public in June, and by September, it was up 140%, only to crash back down to reality. Now the stock trades at a 15% discount of its initial pricing when it went public.
Ultimately, risk and reward are impossible to separate. Understanding that statement is one of the pillars of achieving financial fluency. In order to make higher returns, an investor must assume higher risk. If you believe in a company’s mission, getting onboard an IPO stock could be a phenomenal investment decision. At the same time, one must be wary because the markets take time to arrive at decisions. Determining the value of a company is incredibly difficult and takes years of practice. Investors must consider growth opportunities, revenue potential, and assess the industry that a company resides in.
Only one thing is for certain with IPOs: the price you see when the company goes public is bound to fluctuate before trending towards an equilibrium. By surrounding yourself with a greater understanding of the markets, you can continue to step closer to financial fluency.
In case you missed our last blog, learn how stock in Starbucks has proven to be more than an investment in technology.