Navigating Initial Public Offerings (IPOs): Why Investors Should Proceed With Caution

Companies usually start out as ‘privately held’, owned by the company’s founders and other private investors.

But there might come a time when the company goes public, via an initial public offering (IPO).

A few reasons why a company would consider going public: to raise money, increase the liquidity of their shares for current shareholders, and using stock as leverage in a M&A transaction.

The IPO market can also be a helpful indicator to how the economy and stock market are doing.

During 2021, we witnessed a flurry of IPOs and Special Purpose Acquisition Companies (SPACs"):

Number of SPACs:

Disclaimer: take these charts with a grain of salt. Even if numbers are slightly off, the takeaway is still the same…

Venture capitalists were throwing money around like a drunk at the Golden Banana.

Many companies took advantage of this favorable environment to go public, seeking funds for growth even if they were not yet profitable.

We have seen similar environments before.

During 1983, the total value of new issues was greater than the cumulative total of new issues for the entire preceding decade.1

Then, during the first quarter of 2000, 916 venture capital firms invested $15.7 billion in 1,009 startup Internet companies. 2

Today's environment, however, is notably different, with reduced enthusiasm for funding unprofitable ventures.

But we will certainly see an environment again where IPOs are the talk of the Street.

How Should You View IPOs As An Investor?

Early in my investing journey, I tried the technique of identifying companies that were going public and looked for opportunity.

Seemed easy enough. Get in early and reap the rewards.

But I was sadly mistaken and rather naïve.

Why?

Because these companies hire underwriters, typically investment banks, who put up the money to fund the IPO and buy all of the shares.

Part of their process is determining, “what is this company worth?”

This results in them setting the ‘offering price’, which is the fixed price reserved for a limited group of investors (big institutions), benefiting the company’s founders and early employees.

Retail investors (us) must wait for the stock to be traded on an exchange

The problem? That price is dramatically higher than the offering price due to high demand.

Tread Carefully:

In 2021, the electric vehicle (EV) car maker Rivian, went public. Investors flocked to this name as they envisioned this was the next Tesla.

The initial offering price for Rivian was $78/share. But once it started trading on the Nasdaq, the share price was north of $106/share (the ‘IPO Pop’).

Investors were willing to pay whatever it took to get their foot in the door. At the end of the first trading day Rivian became more valuable than Ford…

However, after the initial surge, the stock has plummeted 80%, leaving many investors with substantial losses on their investment.

General note: utilize a “stop-loss” order on a volatile stock like this to mitigate risks.

These stories remind me of a quote from ‘A Random Walk Down Wall Street’:

“It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored.”

Be careful of buying the “new issue.” IPOs typically get a lot of media attention, generating excitement.

Remember the WeWork IPO debacle?

Or how about Liquid Death, a company who put water in a can, is rumored to be valued at $700 million currently.

IPOs have a history of underperforming the stock market as a whole.

One of these reasons is because IPOs typically include a lock up period, usually a 6-month period where insiders (i.e. key executives) are prohibited from selling stock.

Once the lock-up period ends, large sell-offs can drive down the share price.

Don’t just buy into these new issues because prominent investors, like Warren Buffett or Bill Gates, are involved either.

Odds are these investments account for 0.001% of their overall portfolio and they will sell it before you have any clue as to what’s going on.

IPOs can be enticing and exciting, especially if you are an employee at a company that is going public. The only employees who may not be that excited about going public is the accounting department…

But jumping into new issues may not result in the enormous returns you expect.

Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing includes risks, including fluctuating prices and loss of principal.

Footnotes:

1. ‘A Random Walk Down Wall Street’

2. ‘A Random Walk Down Wall Street’ - Note that not all of these companies went public. It’s a sign of venture capitalists going where the money is and intense speculation.