What is Initial Public Offering? Things You Should Consider Before Investing in IPO
Starting up a business is easy but turning that business into a successful business venture that one day gets listed on the stock exchange is a challenging task that requires a lot of work.
A sole trading business for example, is a single owner business that is the simplest form of a business. Startup owners opt for sole trader business because it does not require a lot of paperwork and legal formalities. However on the down side, the sole trader business is exposed to business risk and the owner can be held personally liable for any losses that cannot be made good through the assets of the business.
Usually when a sole trader business grows beyond a certain size, the owner converts it into a partnership by inducting more partners into the business. New partners can bring in additional and much needed capital. Partnerships also do not require a lot of legal formalities. The profit can be shared according to the formula decided by the owners. The drawback of partnerships is the same, the owners can be held jointly and severally liable for any losses that cannot be met by the assets of the business.
If a business grows beyond this size, then it has to be incorporated. There are two main types of incorporated businesses, namely
- Private limited company
- Public limited company
A private limited company is an incorporated company that is not listed on the stock exchange. The shares of a private limited company can therefore only be offered to friends, family members and other interested investors.
Most companies that become incorporated as private limited companies, remain in this category because this category brings with it limited liability. Limited liability is a concept that means that the owners of the company will not be held personally liable for any losses of the business. Their liability will only be limited to the extent of investment that they have done in the business. The drawback of a private limited company is that it comes with increased regulatory and legal requirements, which add cost but it also allows the owners access to more sources of capital funding.
Another drawback is that venture capitalists and angel investors will want equity and share on the board in return for their investment. This may not be desirable for owners who like to have more control over their business.
The second incorporated model is the public limited company model. A public limited company is listed on the stock exchange, which means that the shares of a public limited company can be offered to the general public.
The benefit of becoming a public limited company is that it allows access to more capital funding and brings in prestige and status to the company. Investors are more willing to invest in public listed companies because listed companies have to go through a strict screening process each year to ensure that their financial records are transparent.
The IPO Process
The process through which any company becomes a public limited company is known as an IPO, it stands for initial public offering. It is a long and arduous process during which the company has to go through strict scrutiny. Once a company is ready to be listed, the banks facilitating and funding the IPO, giving the green light and the deal is then underwritten and the shares are then offered to the public at the initial price set by the underwriting banks. Once the shares enter the market, the market mechanism then drives the share price.
Should I invest in an IPO?
As mentioned above the IPO process puts any company under severe financial scrutiny. Thus, only stable firms are able to pass the scrutiny to be eligible for an IPO. The underwriting banks make sure that their investment is realized with a net gain. So if the banks can place their trust in an IPO, this means that the general public can also place their trust in an IPO.
What mostly happens is that the share prices of a newly listed company tend to rise soon after the IPO due to the market speculation. A freshly incorporated company has got clean books and a future full of expectations. As long as the company is positively viewed by the market its share price will have a positive trajectory.
There is however another perspective when it comes to investing in an IPO. Long term investors may need to invest and hold in a new company because a newly listed company will take years to achieve its proper earning potential. This is where most of the confusion regarding the investment in an IPO arises.
Short term investment in an IPO can be done if an investor can accurately predict the short term price movements. For the long term investment, the investors need to study the company and take their decision accordingly. In the long run, multiple factors impact the profitability of a company.
These factors include
- The sector in which the company is located
- Investment flow into the sector
- Market trends
- Internal control of the company
- Growth strategy of the company
- Other micro and macroeconomic factors
If you are an investor and are thinking about investing in an IPO, then it would be preferable to wait for a short period of time after the IPO. Wait for the IPO price of the shares to be replaced by the market price. If you see an uptick in price, buy the shares and if you see the share price dropping then wait till the drop starts to level off. This strategy ensures that you will purchase the shares on the market price and not on the underwritten price.
Main Image Source: Pixabay