How to Invest in an IPO

After last year’s rally, investors are looking to new issues for market gains. For investors, the first question is how to invest in an IPO.


Word IPO

The proliferation of information in the internet era has brought with it a greater exposure to financial news for all investors. This has helped transform newly issued securities from niche investment options to highly sought-after growth targets. Retail investors have clamored for shares in broadly used social media companies like Facebook (FB) and Pinterest (PINS), market-disrupting service companies like Uber (UBER), Lyft (LYFT) and DoorDash (Dash) and even nascent industries like the recently issued Coinbase (COIN) cryptocurrency exchange. If you’re new to investing you’ve likely heard of all of these companies but may be wondering how to invest in an IPO.

The answer to that question is not quite as simple as it was even as recently as five years ago. In years past, individual investors were largely shut out of new issues due to brokerage firms and investment banks serving as gatekeepers who prioritized only their largest customers.

But times, they are a changin’. Companies seeking to go public identified market inefficiencies that made the old IPO process more time-consuming and costly. This has given rise to two increasingly popular options for going public, via a Special Purpose Acquisition Company (SPAC) or direct listing on an exchange.

How to Invest in an IPO, a SPAC, or a Direct Listing

Each of the three methods for listing a new issue carries unique risks and benefits, not only for the listing company but also for retail investors wondering how to invest in an IPO. So let’s briefly break down each listing process and highlight some important information for investors.

Initial Public Offering (IPO) – During an IPO a company creates new shares with help from major investment banks that assist in meeting regulatory requirements, setting share prices, distributing shares to investors, and stabilizing share prices by buying when necessary. Retail investors can only participate in the initial offering through their brokerage firm, and only when that firm is participating in the offering process. Firms are able to allocate to investors based on metrics of their own choosing and are free to prioritize based on things like the length of the brokerage relationship or assets held there.

This means that even if your broker has shares to allocate you may receive fewer than requested or (in the case of a high-profile IPO) none at all.

Investors that do receive shares enjoy the benefit of an anticipated price range (although IPOs can certainly price outside of their range) and some level of price stability (due to the underwriter).

Those that do not participate in the offering are left with the option of buying on the open market once shares begin trading. That raises volatility and returns risks, which we’ve written about before.

Special Purpose Acquisition Company (SPAC) – A SPAC is a relatively recent vehicle in which a large investor or asset manager pools capital with the intent of taking a private company public. This is very valuable for the private company, as they can guarantee a total sale price for the operation without worrying about share pricing. (A SPAC, for instance, may offer to buy a company for $1 billion, independent of where shares trade following the acquisition.)

We’ve written before about the pros and cons of SPACs but the key takeaway is the speculative nature of SPACs as investment vehicles.

A SPAC typically issues shares at $10 with the intent of taking a specific company public, those shares then fluctuate based predominantly on market news. An acquisition target is free to find other suitors, negotiate sales price, or just flatly refuse the offer. This can leave SPAC buyers holding the bag if they bought overvalued shares anticipating a merger, only to have offer terms change or the merger fall through.

Direct Listing – In a direct listing a private company does not create new shares but brings privately held shares of investors and insiders to the public marketplace. Direct listings receive a reference price before trading which can be based on recent private secondary market trading prices, an average of those prices over a specific period of time or a price at which private shareholders would be willing to sell.

Companies choosing to go this route avoid dilution for existing shareholders and significant cost savings as compared to a traditional IPO. However, they face significant enterprise valuation risk should the market be unwilling to support the proposed reference price (on the flip side, there is also potential for the enterprise to be significantly overvalued should the investing public drive up pricing).

The benefit to retail investors is that they’re on a level playing field with anyone else seeking to buy shares, including institutional investors. Given the relative scarcity of direct listings, however, there’s little history to mine for insight. Anecdotally, Spotify (SPOT) (one of the first companies that began trading via direct listing) opened trading about 25% higher than its reference price.

As the new issue marketplace continues to evolve we’ll likely see companies come public through a combination of all three of these methods, and whether the next hot stock is an IPO, SPAC, or direct listing, you now know the unique risks of how to invest in an IPO.

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