How does an initial public offering work?
An IPO, or initial public offering, is when a private company sells shares to the public for the first time and lists them on a stock exchange. Companies usually go public to raise money, let early investors sell, and raise their profile, but listing brings stricter reporting rules and higher costs. Read our full guide to what an IPO is and how it works.
How can you invest in an IPO?
There are two ways to buy shares in a company that’s going public.
The first is to apply for shares in the offer, before the company lists. This is buying in the primary market. If your application succeeds, you pay the offer price, which the company and its banks set through bookbuilding, using investor demand, the company’s valuation, and market conditions. Though the majority of shares tend to go to institutional investors, some IPOs include a retail offering for individual investors to apply for through their platform.
The second is to buy once the shares start trading. This is buying in the secondary market, at the live market price, which can be above or below the offer price.
To see which IPOs you can apply for, and how applications work on Freetrade, visit our IPO hub.
Why investors are interested in IPOs
Investors can get pretty excited about public listings. It’s the first time they may have the opportunity to invest in a company previously restricted to founders, employees, and private equity investors.
IPOs can also give investors access to growing businesses trying something new. Going public can represent a new lifecycle stage for these companies.
This means they might also represent a sector or theme not already well represented in an investor’s portfolio.
Main risks of IPO investing
Newly listed companies have limited available information and no public share price history. That can make research harder than for a more established listed company. It also means investors have less insight into how the share price might behave in different market conditions.
IPOs are very hard to price accurately and prone to wild swings as the new shares settle into the market.
When shares first become available on the public market they may be subject to a period of conditional dealing, during which trades are not guaranteed to go through. Find out what happens on the first day of trading.
And that’s just the initial bumpiness. Over the long term, there are other risks.
At IPO, some companies are still scaling, selling shares to fund capital reinvestment into the business. Some may not yet be profitable, and trade at a premium based on potential they may never reach.
There’s also allocation risk. If an IPO is popular, applicants might not receive the full number of shares they applied for. If it’s extremely popular, they might be lucky to receive any at all.
It’s also worth noting IPO investing also carries the same risks associated with investing in other equities. For example, be aware IPO investments may leave your portfolio exposed to particular currencies, geographies, and sectors, particularly if you have not diversified.
Lock-up period risk
One key risk to flag is a stock’s lock-up period. This is a set time after the IPO when existing shareholders agree not to sell their shares. Lock-ups commonly last 90 to 180 days in the US but in the UK it’s often longer than 12 months. Terms vary, and some run longer or release shares in stages.
Once the lock-up period expires, significant selling can occur as shareholders look to take advantage of being able to use the secondary market. This may put pressure on a company’s share price, and could even signal that insiders’ confidence in the business is low.
Lock-up periods are not mandatory, but they are common. They are usually disclosed in the prospectus a company releases pre-IPO.
What to check before investing in an IPO
Before investing, make sure to do your due diligence. Here is a checklist:
- Read the prospectus. Read it carefully. It should explain the company’s business model, financial performance, key risks, debt, use of proceeds, major shareholders, and any lock-up arrangements.
- Do you know what the company does? If you cannot understand how a company makes money, it might not be the right investment for you.
- Do you understand the risks? A business might be highly exposed to certain markets, commodity prices, or other factors. It might have a lock-up period that could lead to a period of legacy shareholders selling.
- What’s the valuation? It might not be the best idea to buy at IPO just because a company is making money and you think its business plan looks solid. Compare the company’s valuation with its peers. How does its revenue growth, profit margin, and balance sheet stack up with competitors?
- Check the use of IPO proceeds. Why did the company raise money? Are the proceeds being used to invest in growth, repay debt, or provide liquidity to existing shareholders? Make sure you are comfortable with the company’s intentions. After all, it might be your money they are using.
- Does the investment fit your goals, risk tolerance, time horizon, and diversification needs? Can it be held in your ISA, SIPP, or any other investment account you plan on using?
- Are you on the hype train? IPOs can seem exciting and time sensitive, leaving some investors feeling a bit of FOMO. Don’t let this cloud your judgment. Make sure to check whether the investment is right for you.
- Read up on how applications work before you apply. Check how much you can apply for, when your money is taken and returned, what happens if you’re allocated fewer shares than you asked for, and whether FX fees apply if the IPO is in another currency. Our IPO hub answers these questions for IPOs on Freetrade.
- What can you afford to lose? Investing at IPO can be high risk, even if a company seems well-known and reputable. Don’t invest with money you cannot afford to lose, like cash you might need for an emergency fund, personal expenses, debt repayments, or other key expenses.
.avif)
