IPOs are exciting. There’s always excitement around something new and a new public listing offers both novelty and – potentially – profit. If the IPO is widely hyped and much-awaited the excitement multiplies and leaves ordinary investors wondering how to buy IPO stock.
IPO participation has traditionally been dominated by large institutional investors. It still is, but opportunities for smaller investors to buy IPO shares are increasing. You may even be able to buy pre-IPO shares if you’re willing to take the considerable risks involved.
Just because you can buy IPO shares doesn’t mean you should, of course. There’s an opportunity for real gains, but the risks are also significant.
Let’s take a closer look at how to buy IPO stock, and at some of the risks and advantages.
How Does an IPO Work?
Businesses typically start their lives as privately-owned companies. Seed capital may come from the founders, from loans, or from venture capital investors who buy stakes in private firms.
When companies reach a certain size their owners may decide to issue shares and sell them to the public to raise additional operating capital. There are three common ways for companies to do this.
- Reverse merger: a private company will acquire an inactive public company and merge with it to take over its public trading status. This is generally the fastest and easiest way for a company to go public and is sometimes used by companies that are not fully ready for public status
- Special Purpose Acquisition Company or SPAC: Investors form a publicly-traded company with no operations and raise money to acquire a private company, bringing it into public status. Some prominent companies have used this route, but it’s often associated with less respectable deals.
- Initial Public Offering or IPO: the most conventional and respectable way for a company to go public, and also the most expensive and complex.
Most large and well-known private companies will choose to go public through an IPO. Investment in a reverse merger or SPAC can be viable but must be approached with extreme caution.
Public trading status can raise a significant amount of money for a company, but it’s also a burden. Preparing the numerous reports required by the SEC and complying with the regulations applied to public companies can be a significant expense: most public companies maintain a dedicated compliance department. Going public too soon can do a company real harm.
A company that intends to hold an IPO will approach an investment bank or consortium of investment banks, which become the underwriters of the IPO. The underwriters will assess the value of the company and the number of shares to be offered and set an offering price for the shares.
The company must file an S-1 Registration Statement with the Securities and Exchange Commission, including a prospectus with extensive financial information and a privately held filing document with complete ownership information. The S-1 is the primary source of information on a company that’s going public.
Once the S-1 is approved the underwriters will set a date for the IPO and finalize an offering price. They will offer shares to institutional investors and allocate shares to major brokerages. The brokerages can then sell these shares to their clients. These are the shares that may be available to retail investors that know how to buy IPO stock.
IPO shares often come with a lockup period, meaning that investors who purchase shares at the IPO must wait to sell their shares. Lockup periods typically last 90 or 180 days.
How to Buy IPO Stock
There are several hurdles you’ll have to clear before you can purchase IPO stock.
1. Have an Account With a Participating Broker
IPO underwriters make shares available to the public by assigning share allocations to brokers. The brokers then divide up these share allocations among clients who have expressed an intention to buy the IPO stock.
There is no way to be sure that any given broker will receive a share allocation for the IPO that you want to buy. Major brokers are more likely to receive allocations, but there is also more likely to be buying competition from other clients. Large or active clients are likely to get priority in share allocations.
Many brokers limit IPO participation to established clients, so you probably won’t be able to get in on an IPO by opening an account with a participating broker.
2. Consider Desirability
You’ll need to take a very close look at any company you’re considering buying at an IPO. Read the prospectus carefully, know the business and the competitive landscape, and consider the potential risks. The wildly successful IPOs get the publicity, but many IPOs take years to generate returns if they do at all.
If your broker is actively promoting IPO shares, be careful. The IPO may be undersubscribed, which means that other investors aren’t picking up the allocations. That’s often a sign that the IPO is overpriced or there are perceived issuers with the company.
3. Meet Eligibility Requirements
The Financial Industry Regulatory Authority has rules, specifically Rule 5130 and Rule 5131, defining eligibility for IPO purchases. If you are an employee of a close relative of an employee at a portfolio manager, broker-dealer, or other financial institution that is a FINRA member you may not be able to participate. If you aren’t sure, check with the compliance department of the company that employs you or your relative.
Your broker may have additional eligibility requirements. They may require a specific account balance, a level of family assets, or an established trading history. Some brokers may restrict IPO purchases to investors who meet the SEC’s Accredited Investor Criteria.
Here are the IPO participation requirements for some major brokers.
- Charles Schwab allows IPO participation for investors with an account balance of at least $100,000 or a history of at least 36 trades.
- E*Trade does not have a minimum account balance or trading history requirements for IPO participation. The IPO underwriters may require you to fill out an eligibility questionnaire.
- Fidelity allows clients who meet a minimum household asset requirement or are members of their Private and Premium client groups to participate in IPOs.
- TD Ameritrade allows IPO participation if they are part of the selling group for the specific IPO in question. Participants must have made 30 trades in the last calendar year or have a minimum account balance of $250,000.
- Robinhood allows IPO participation for most clients.
These requirements may change and other brokers may have their own requirements. Check with your broker to be sure.
4. Request IPO Shares
Your broker will have a system for requesting shares in the IPO. You’ll have to fill out a form, which may be called an “indication of interest” or some similar name. You’ll tell the broker that you are interested in buying the stock and how many shares you want to buy.
5. Order IPO Shares
If the IPO proceeds on schedule, you’ll be notified by your broker. Final IPO dates may be set just before the IPO happens, so you may not have extended notice. Your broker will provide the final IPO price and a deadline for placing an order. You’ll place your order using your broker’s usual buying system.
Placing an order does not guarantee that you’ll get the number of shares you asked for. You may get fewer, or none at all. Your order defines the maximum number of shares you’ll get and the maximum price you’ll pay.
Your broker will tell you how many shares you were actually able to purchase.
This system may vary from broker to broker. Consult your broker for their specific instructions.
Should You Buy IPO Shares?
Now you know how to buy IPO stock, but should you?
The main argument for buying IPO shares is that they get you in “on the ground floor”, allowing you to acquire shares in a company with high growth potential at a rock bottom price. That sounds compelling, but it isn’t always accurate.
For example, this article from CNBC announces that “Tesla stock is up more than 4000% since its debut 10 years ago”. That’s true. The IPO price of Tesla stock was $17, and on the article’s publication date the stock was worth $1,009.35.
That kind of news leaves many investors eager to snap up the next heavily hyped IPO, hoping that it will be another Tesla. But did you really need to buy at the IPO to get those gains? Let’s take a closer look.
Herer’s a chart of Tesla’s stock price. Remember that the stock commenced trading at $17 on June 29, 2010.
If you had bought Tesla stock in June 2011 – a year after its IPO – you’d have paid around $8. That’s around half the IPO price. Tesla shares dropped after the IPO and didn’t get back to the IPO price until May 2013, almost three years later. You didn’t need to buy at the IPO to get the best price. You had a three-year window in which you could have bought below the IPO price.
There are cases where the IPO price was the cheapest entry point in a stock’s history. For example, BioNTech (BNTX) went public on October 19, 2019 at $15 per share.
As we see from the chart, the stock climbed steadily and never fell below its IPO price. Despite that steady climb, you could have bought the stock in January 2020, several months after the IPO, for under $30 a share. You wouldn’t have seen the same gains as you would from an IPO purchase, but you would still have turned a tidy profit.
Now let’s look at discount broker Robinhood, which went public amidst heavy hype on July 28, 2021, at $38 per share. The stock shot up to over $44 and then… well, see for yourself:
If you’d bought at the IPO, the lock-in period would have locked you into a substantial loss.
What these stories tell us is that in most cases, you don’t need to get in at the IPO to get the best price. Many IPO companies that eventually thrive go through a period of trading near or below their IPO price before their value increases. Other companies quickly drop to well below their IPO price.
Lock-in periods also mean that many IPO investors are suddenly able to sell their stock when the lock-in period expires. That can lead to a surge in selling and a drop in the stock’s price. If you’re interested in a company and can’t (or don’t want to) buy at the IPO, the expiry of the lock-in period is often a buying opportunity.
Even companies that see a continuous rise are often available at little over their IPO price for some time.
There are advantages to simply waiting for a stock to commence public trading. You don’t have to apply through your broker or worry about getting a share allocation. You can buy as few or as many shares as you like. You’ll have some idea of how the market is responding to the stock. You won’t have a lock-in period: you can sell any time you like.
There are cases in which buying at the IPO will get you the best price you’ll ever get on a stock, but those cases are actually relatively rare. Unless you’re absolutely sure the stock is set for an immediate uninterrupted rise – and experienced investors are rarely absolutely sure of anything – it’s often best to wait. Patience is a virtue!
Many IPOs are heavily hyped and widely discussed. Your favorite online investment discussion board may be buzzing with discussion of companies that are considering IPOs and their potential for success. Knowing how to buy IPO stock and getting approved for an IPO purchase can make you feel like a member of an “inside group”, a step forward in your stature as an investor.
That excitement can be dangerous. IPOs can be risky. We always hear about the successful IPOs and how much we could have gained if we’d gotten in on the IPO, but the truth is that for every IPO that soars out of the blocks there are many more that stutter, and several that stage epic face-plants.
There’s nothing wrong with buying at an IPO if you’ve considered the risks and you’re convinced that the company has a strong future. As a general rule, IPO investing should be seen as the start of a long-term process: the most successful IPO investors tend to hold their shares for an extended period.
Again, look at the Tesla chart we showed above. To take full advantage of that investment you wouldn’t just need the foresight to buy in early. You’d also need the patience to hold that investment for several years with little or no appreciation.
If you can’t get in on an IPO or you don’t think it’s worth the risk, don’t write off the stock. There’s a high chance that you’ll be able to get in at a good price after the IPO. Watch for dips, pay attention to the end of the lockout period, and make your move at the time that suits you best!
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