Why IPOs Make Terrible Investments

Joseph Hogue's picture

Thursday, February 9, 2017 - 12:00am

by Joseph Hogue

Too many investors think chasing the next hot IPO (initial public offering) is a surefire way to get rich.

They see how Facebook (NYSE: FB) has jumped 242% since it went public back in the summer of 2012. Or they hear about how LinkedIn (NYSE: LNKD) doubled in price less than five years after its IPO.

These investors think that by buying shares in a hot new company as soon as it goes public, they’re getting in before the rest of the crowd catches on.

But here's what they don't know -- by the time a company goes public, it's no longer "on the ground floor." It's more like on the fifth or sixth floor because early investors -- founders, venture capitalists, and private equity firms -- have already bid up the value of these young companies when they were privately-owned and in their "mega-growth" phase.


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Missing Out On The "Mega-Growth" Phase
Let's say a brand-new company is ready to start raising funds to get its amazing invention idea off the ground. A seed-stage investor may only need to invest $5,000 for a 1% ownership in a $500,000 company.

If the early-stage production tests go well, the young company will seek out another round of funding (a "Series A" round) for mass-market production -- that's the first big money coming in. At that point, venture capital firms might become interested and invest a few million dollars or more. After several more rounds of funding to invest in product development and mass-market production readiness, that still-private company may be valued at $3 million.

If the company still hasn't been acquired by a competitor, then it may raise one last funding round for the regulatory and other costs to issue public shares in an IPO.

By the time an IPO happens and can be bought by anyone, the pre-IPO investors are looking to sell their shares and take their profits (as they did with Facebook shortly after it went public).

The insiders sell because they know the real gains are already made by the time the company goes public. As proof, a 2016 University of Florida study found that IPOs issued between 2000 and 2011 underperformed their same-sized stock peers by an average of 18% in their first year of going public. And between 1970-2011, the study found that IPOs underperformed their same-sized peers by an average of 3% in the first five years of being publicly traded.

Lesson: If you want to make money, get into the elevator before it starts moving.

Sure, Facebook and LinkedIn made everyday investors triple-digit gains even after they went public. But did you know that early-stage investors who invested $1,000 in seed money in LinkedIn long before it went public would have walked away with over $87,000 on their investment today?

Or consider Peter Thiel's 2004 investment of $500,000 in Facebook as its first outside investor. He walked away with $1.7 billion, good for a 3,400% return on his investment by the time it went public in 2012. Other pre-IPO Facebook investors that put in $1,000 would have walked away with over $811,850 today. Those are literally 1,000%-plus returns in less than a decade.

In other words, the real way to make money in early-stage companies is to buy them before they IPO.

In the past, buying a company "pre-IPO" was reserved for only for the richest American investors who met the SEC's strict net-worth requirements. But recently -- May 16, 2016 to be exact -- the SEC began allowing individual investors to buy companies before they go public, giving you an opportunity to earn 1,000%-plus gains the same way Peter Theil and other pre-IPO investors have done.

With the new SEC rules in mind, I talk about how ordinary investors can buy stakes in pre-IPO companies with stellar growth potential in my brand-new book, Investing in the Next Big Thing: How to Invest in Startups like an Angel Investor. Best of all, StreetAuthority readers will get to read an exclusive bonus chapter revealing 3 startups that I'm telling my clients to buy now. Get full details on the book here.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.