Here’s The Truth About IPOs That You Need To Know…

Have you ever been tempted to buy shares of a company after it goes public?

You wouldn’t be the first investor to get excited about an upcoming initial public offering (IPO).

The Wall Street media hype train is real. The thought of getting in on the “ground floor” of the next Google, Microsoft, or Facebook is often too good to pass up.

There’s just one problem.

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.

We’re 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. We’ll explain why in just a second.

But first, we 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.

The underwriters help form the preliminary prospectus, often called the “red herring.” This outlines the company’s financials, use of proceeds, vision, and market research, among other things, to present to potential investors.

Ironically, a “red herring” is an idiom that 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 and/or options to purchase shares at a specified price…

This is 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.

A Classic Example

Let’s take a look at the 2019 IPO of ride-hailing company Lyft (Nasdaq: LYFT), for example.

Activist investor Carl Icahn, an early investor, 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 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 require the entities or individuals to hold shares for a certain period. For example, Lyft’s chief operating officer had over 831,000 RSUs worth a cool $64.8 million on the first trading day. However, he couldn’t unload any of these shares until the vesting period had 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. The hype has its limits.

Just take a look at what happened with Lyft after the IPO. The stock went into a freefall before the Covid pandemic even hit. The stock never recovered. Today, it’s practically left for dead…

But it’s not just Lyft we’re talking about here. Let’s look at what happened with a stock like Facebook (now known as Meta), 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%. They would subsequently fall nearly 50% from their initial offering price of around $38.

Facebook IPO chart

This is 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.

But just because a company sometimes flops after its IPO doesn’t mean it’s a bad investment. as As we know, shares of Facebook are up big-time since the initial public offering. But how many average investors could withstand seeing their investment tumble by 50% and not sell? The toil it takes is often too much to handle.

On the flip side, think about what happened to patient Facebook investors who waited for the dust to settle and got in at just the right time. Of course, timing these things is incredibly hard to do alone. But buying right into the early days of an IPO is possibly one of the worst times to buy any stock.

Action To Take

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

Consider waiting about six months after an IPO before even seriously evaluating it. 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. This also provides enough trading data to see where support and resistance levels lie and what the market thinks of the stock.

Lyft wasn’t the first and won’t be the last IPO that gets a ton of attention. There will be other exciting IPOs that will come after it. But don’t get sucked into the hype.

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