Here’s Why Investing In IPOs Is Almost Never A Good Idea…

“I wanna go big with it…”

This was a text I received a couple of years ago from a friend about an upcoming initial public offering (IPO). The ride-hailing company Lyft (Nasdaq: LYFT) was about to go public, and they were clearly excited.

The person who sent the text was asking me about my opinion of the company. Yet, regardless of what I had to say he was going to invest in it anyway. The hype train was moving along at a good clip and he felt he would be missing out if he didn’t get in on the “ground floor” — even after I told him it was unwise.

Too many investors think chasing the next hot IPO is a surefire way to get rich. They believe that by buying shares as soon as it goes public, they’re getting in on a “sure thing” before the rest of the crowd.

Unfortunately, that’s usually far from the truth. The fact is that most of the money has already been made.

I’m not saying that an IPO won’t eventually pan out. Indeed, it could eventually make investors a lot of money. But chances are, at least in the short-to-medium term, you’re more likely to lose money. And in order to understand why, we first need to understand what it takes for a company to go public.

The ABCs Of IPOs

Most entities looking to go public bring in underwriters to help navigate the company through the entire process — in Lyft’s case JPMorgan Chase (NYSE: JPM) led the offering along with Credit Suisse Group (NYSE: CS), Jeffries Group LLC and 26 other financial institutions. The filing fees to go public amounted to a staggering $6.5 million for Lyft.

The underwriters help form the preliminary prospectus, often referred to as the “red herring”. This outlines the company’s financials, use of proceeds, vision and market research, among other things, to present to potential investors. I always found it humorous that this is called a “red herring,” because the idiom refers to something that misleads or distracts.

The underwriters then use this red herring to generate interest and attract buyers. Most of the time, companies will do what is called a “road show,” where they host events to pitch the merits of their company to the big institutional investors: investment banks, private-equity firms and hedge funds.

In exchange for investing in the company looking to go public, the investors get an equity stake in the company and/or options to purchase shares at a specified price…

And it is here where most of the money is made.

These early investors get the best deals. And by the time the company goes public, they will have made their money many times over. Activist investor Carl Icahn, who was an early investor in Lyft, sold his shares just before the company went public, booking a small fortune before shares were even tested in the public market.

Lyft granted directors, officers, employees, consultants and other service providers options to purchase its common stock at exercise prices ranging from around $13.16 to $13.43 per share. The company’s initial public offering price was $72 per share and shares closed at $78.29 on the first day of trading, an 8.7% increase. Shares traded as high as $88 that first day.

If you acquired shares on the “ground floor” of around $13 per share, and they closed at $78 per share on their first trading day, it would be awfully tempting to book that 500% gain. And that’s exactly what many of these companies and people do. The “smart” money was selling.

Of course, not everyone can sell shares on the first day a firm goes public. Many of these shares are Restricted Stock Units, or RSUs, which requires the entities or individuals to hold shares for a certain period of time. For example, Lyft’s chief operating officer has more than 831,000 RSUs that were worth a cool $64.8 million on the first day of trading. However, he couldn’t unload any of these shares until the vesting period has passed, typically starting three to six months after the IPO.

Now, put yourself in the shoes of a person inside the company with RSUs. Can you imagine? As each date passes where you can begin selling those RSUs, you’re heavily incentivized to go ahead and book at least some of those gains.

The Truth About IPOs

It’s often the case that the bigger the buildup for an IPO, the bigger the fall over the subsequent months. Hype has its limits.

Just take a look at what happened with Lyft after the IPO. The stock went into a freefall, well before the Covid pandemic even hit. The stock has climbed much higher since then, but still has yet to recover the levels it was at upon going public.

But it’s not just Lyft we’re talking about here. Let’s take a look at what happened with a stock like Facebook (Nasdaq: FB), which has delivered some fantastic gains to long-term investors.

Facebook had its IPO in 2012. The day after the company went public, shares plummeted 10% and would subsequently fall nearly 50% from their initial offering price of around $38.

Facebook IPO chart

It’s a common occurrence with IPOs. Institutional investors like to cash in their big profits at the expense of the little guy, who’s buying the initial hype. Now, just because a company sometimes flops after its IPO, it doesn’t necessarily mean it’s a bad investment. Again, shares of Facebook are up big-time since the initial public offering. But how many average investors were able to withstand seeing their investment tumble by 50% and not sell? The toil it takes is often too much for most investors to handle. The hot air is quickly released, buyer’s remorse sets in and they sell their shares at the bottom (often right back to the “smart money”).

On the flip side, think about what happened for patient Facebook investors who waited for the dust to settle and got in at just the right time. Those people are much likely to have enjoyed the major gains of Facebook (or Meta Platforms, as it is now known), since the IPO.

Of course, timing these things is incredibly hard to do on your own. But one thing we know is that buying right into the early days of an IPO are possibly one of the worst times to buy any stock.

Action To Take

My point is that anytime you see an IPO being hyped up, show some healthy skepticism. Do your due diligence. Don’t feel as if you’re missing out by not buying on the first day of trading. Remain patient. Let the dust settle, and then go back and revisit the stock.

I like to wait about six months after an IPO before I even consider investing in it. This is for two reasons. One, after six months, many of the “lock-up” periods for the RSUs have expired, meaning that much of the big money has been allowed to sell their shares if they so desire. And, two, a half-year provides enough trading data to begin seeing where support and resistance levels lie, and what the market really thinks of the stock.

Lyft wasn’t the first and won’t be the last IPO that gets a ton of attention. For example, the electric auto maker Rivian (Nasdaq: RIVN) just went public last week. There will be other exciting IPOs that will come after it. But don’t get sucked into the hype.

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