Initial public offerings (IPOs) present a unique opportunity for the experienced investor. They allow you to buy stock in companies that are transitioning out of private ownership and "going public." The IPO market was especially busy in 2021 with nearly 400 companies going public and raising $142.5 billion in the process, according to research from investment bank Renaissance Capital.
The question then turns to how to invest in an IPO. You'll first have to partner with a brokerage firm that has access to IPO investments. Here's how it all works.
What Is an IPO?
Startups can secure capital in any number of ways, from self-funding and small business loans to angel investors and venture capital firms. At a certain point, many business owners choose to go public as a way of generating more money to fund growth and expansion. This means they'll begin offering shares of its stock for sale to the public. When an investor buys stock, it gives them a partial ownership stake in the company.
The goal of IPO investing is to get in early and buy low before the company takes off. If stock prices eventually go up, investors could turn a profit by selling high. Netflix's IPO, for example, was priced at only $15. By November 2021, its stock price had soared to more than $657. But shares have fluctuated along the way and have since dropped to just over $350. This is precisely why IPOs are considered high-risk investments.
Who Can Buy IPOs?
IPO stocks are typically reserved for a select group of investors through brokerage firms participating in IPO launches. Every brokerage is different, but most require investors to meet certain requirements. Securing shares can still be challenging if demand outweighs supply. Participating firms only receive a certain number of shares, so they use their own discretion in deciding which investors will have access to them. According to Fidelity Investments, eligibility requirements often include:
- Holding a significant amount of assets with the brokerage firm
- Meeting minimum trading frequency requirements
- Maintaining a long-term relationship with the firm
Snatching up IPO stock isn't always easy. Most IPOs are offered through a group of underwriters. They buy shares from issuers, then turn around and sell them to investors. Not all brokerage firms find their way into these selling groups. Regardless, institutional or wealthy investors are often at the front of the line, especially when a much-anticipated company makes its public debut. It can be a similar story even when there isn't much fanfare around an IPO. This is because most underwriters assume that these types of investors have a higher risk tolerance and are more likely to buy large chunks of IPO shares.
This isn't to say that individual investors can't buy IPO stock—it's just that they might need to have a long-standing relationship with a brokerage firm that has enough shares to coordinate the deal.
How to Invest in IPOs
- Find a brokerage that sells IPO stock. E-Trade, TD Ameritrade and Robinhood all fit the bill.
- Clarify their eligibility requirements. Be sure to read the fine print. TD Ameritrade, for example, discourages investors from flipping IPO stock within 30 days of its offer date. Investors who do so could be barred from future IPOs.
- Make a conditional offer on an IPO stock. You place this offer prior to the IPO being priced, and it does not guarantee that you'll receive shares. You can modify or cancel a conditional offer until the SEC declares the company's registration statement effective. Your conditional offer will then become a firm offer. If shares are to be allocated to you, you should see them in your account shortly after.
Should You Invest in an IPO?
Investing in an IPO could eventually lead to a nice payday, but it's also inherently risky. Below are some important pros and cons to consider:
- The potential to grow your wealth: You could buy stock at an initial offer price that's much lower than its future market value. LinkedIn's IPO, for example, was priced at $45. Shares were selling for more than twice that after its first day of trading. The company was later acquired by Microsoft for $26.2 billion—and LinkedIn shareholders received $196 per share.
- Diversification: A strong investment portfolio usually reflects a healthy mix of different investments. This can include mutual funds and exchange-traded funds, bonds, real estate and IPO stocks. The idea is to spread out risk so that all your eggs aren't in one basket, so to speak.
- Not every IPO is a winner: It's impossible to predict which companies will soar after going public. Twitter's IPO, for example, debuted at $26 in 2013. The stock price at the time of this writing is just over $38. If you look at its trajectory since its IPO, its stock price has seen highs and lows but hasn't experienced explosive growth like some other companies. There are also companies that burn out altogether and quickly lose stock value after an IPO.
- Investing in an IPO can be tricky: As mentioned earlier, you'll likely have to jump through a number of hoops to secure IPO stock. Those who meet their brokerage's eligibility requirements might still find that there aren't enough shares to go around.
The Bottom Line
After learning how to invest in an IPO, you may decide that other high-return investments are a better fit. Just be aware that they each carry a good deal of risk. Before investing, it's wise to make sure your financial house is in order. Paying down debt and building your emergency fund are key parts of financial wellness. The same can be said for maintaining healthy credit. Experian offers free credit monitoring, which provides a simple way to stay up to date with what's on your credit report.