If you had invested $1,000 in Amazon when it went public in 1997, your stock would be worth more than $1 million today.
With the benefit of hindsight, investors can look at securities like FAANG stocks — Facebook, Amazon, Apple, Netflix, and Alphabet (formerly Google) — and wistfully regret missing out on investing in a successful IPO. An IPO, or an initial public offering, is when a privately held company makes its company’s shares available to investors in the stock market.
Yet sometimes, naive investors are attracted to the glitter of fool’s gold. During the dotcom bubble of the late 90s and early 2000s, many internet startups garnered hype but failed to live up to their expectations.
Take Pets.com, for example. During its first fiscal year in 1999, the pet store delivery service earned just $619,000 in revenue but spent $11.8 million on advertising. Buoyed by this publicity, including a Super Bowl commercial and a balloon in the Macy’s Thanksgiving Day Parade, Pets.com raised $82.5 million in its initial public offering in February 2000. Despite investor confidence, though, Pets.com struggled with an unsustainable business strategy; less than a year later, the company was bankrupt.
Unsurprisingly, the risk that comes with investing in an IPO can be just as high as the potential of its reward. Anticipating how well that company will perform in the future can be tricky, and uninformed investors can be blinded by hype. On the other hand, research and caution might mitigate the risk of investing in an IPO. Before investing in an IPO, investors should consider the full scope of their decision.
REVIEW THE S1
A glossy Super Bowl commercial may be more entertaining than reading a prospectus, but investors will be much more informed about a company’s strategy and opportunities with their legal registration documents than their marketing materials.
In the U.S., investors can research a company before it begins trading by reading the SEC Form S-1, which companies must file with the U.S. Securities and Exchange Commission. With this form, the company must include its prospectus, which describes its business operations, financial condition, results of operations, risk factors, management, and audited financial statements. This can help investors analyze a company’s earnings, individual risk factors, and potential value.
IDENTIFY THE MARKET OPPORTUNITY
In the prospectus, a company should be clear about their business plan and products or services they are selling. If you can’t understand the business or the problem they aim to solve, then the company’s business plan may be unsteady.
After understanding the business’s goals, prospective investors should determine where that product or service fits into the market. Is there a sizable market share the company can capture? Is there a need that this business can fulfill? There may be other factors that affect the company’s position in the market, such as the number of competitors and the quality of the product.
Moreover, investors should consider the company management and their history with this market. Research whether they have prior experience in the industry, how long they have been with the company, and how well rounded the board is for a better understanding of the company’s place in the market.
CONSIDER WHY THEY WENT PUBLIC
Companies may use the proceeds from an IPO for a number of reasons, including debt repayment, investment, marketing and sales promotion, and/or other corporate purposes. According to some research, the firm’s primary use of these proceeds may indicate its future performance.
In 2017, researchers from the Université du Québec published a study in The Quarterly Review of Economics and Finance that reviewed the motivations of why a company went public as well as their post-IPO performance. The researchers found that businesses who used the proceeds from an IPO to eliminate debt tend to underperform in the following three years compared to companies that used their proceeds for other purposes.
Understanding where that money is going can help investors make informed decisions. Generally, companies putting funds towards growth initiatives will have a greater incentive for expanding the business, which can result in a more stable investment.
WAIT OUT THE LOCK-UP PERIOD
The lock-up period is the time during which shareholders and company insiders are prohibited from selling their shares, usually lasting between 90 and 180 days. During the lock-up period, there is no indication of how insiders would feel about the stock. However, by waiting until they are free to sell their shares, investors can see how confident those shareholders are about the stock.
Investing in a profitable company can be an exciting part of your portfolio, but filtering out the less promising IPOs requires research and carries fundamental risk. Still, by reviewing the company’s reports with a healthy amount of skepticism, there may be an opportunity to find the next big winner early.