An initial public offering, or IPO, is Wall Street’s equivalent of a massive launch party or milestone birthday.
When a company announces it will transition from privately held to publicly traded, it offers shares of its company on a stock exchange to potential investors.
Going public, as it’s known, marks the passage from the days when a company answered to a small number of investors to a stage where it must appease a large group of shareholders.
No matter the stage you are at in figuring out how to invest money, IPOs may be alluring if you want to invest in a company’s early days as a public entity.
Here’s what you need to know about IPOs, how to invest in them and the associated risks.
What is an IPO?
An IPO is a demarcation separating a once privately held company from a public entity.
But it also cues a broader swath of changes that a company must make when going public, not least of which is providing more comprehensive financial information to investors.
IPOs are far from secret. There often are rumors about companies that may go public in the near future — but that’s pure speculation until a company makes a formal announcement of its intentions.
From there, it can take several months before the IPO is finalized.
In the interim, investment bankers will estimate the company’s valuation to decide both the amount at which shares will be priced and how many shares will be offered to investors.
For companies, IPOs offer the opportunity to raise a lot of cash quickly, which can fund projects and help it to expand operations.
For investors, IPOs can be an attractive, and lucrative, opportunity to invest before a stock appreciates in value.
But buyer beware: Even stocks that eventually become runaway successes can struggle to trade above their IPO price for months or even years (Facebook is but one example).
How to invest in an IPO
Do you have a brokerage account? Great, you can invest in an IPO.
Once the pricing details and date for an IPO are finalized, mark your calendar: This will be the date when shares of the newly public company are available to buy.
But here’s where IPOs can be deceptive. The offering price announced before the IPO is reserved for a limited group of investors.
That group includes employees and those investors who satisfy certain eligibility requirements (like the size of their assets or how frequently they trade).
For most investors, investing in an IPO means buying the stock once it begins trading on the open market. The opening price, which will reflect demand for the stock in question on the day it debuts, could differ dramatically from the offering price.
What’s more, the IPO stock can spike higher — and quickly. Snap, the parent company of Snapchat that went public in 2017, jumped more than 40 percent its first day of trading.
Risks of investing in an IPO
There are risks inherent to investing because no investment is a sure thing — and IPOs are no exception.
IPOs are especially appealing to some investors because they appear to offer a tantalizing get-rich-quick opportunity.
But there have been some famous flops over the years. Take Pets.com, which liquidated less than a year after its IPO, or Groupon, which has yet to see its stock anywhere near the level at which it debuted.
Make sure you know the risks associated with investing in individual stocks before doing so. Don’t invest in an IPO just because it’s new to the market, you perceive it to be cheap or you believe you have some sort of inside information.
Take the same approach to investing in IPOs as you would any other stock, and make sure you understand how to research stocks before buying. Doing this type of fundamental analysis will ensure the stock deserves a spot in your portfolio.
Finally, never let a single investment — IPO or otherwise — skew your portfolio’s allocation in a way that could be detrimental to your long-term goals.
Building a diversified portfolio that includes a variety of assets will help reduce your overall risk.
You may celebrate getting in early on the latest IPO if it proves to be a success on Wall Street, but you will be cursing that same stock if it blows up your portfolio.
Anna-Louise Jackson is a writer at NerdWallet. E-mail: firstname.lastname@example.org. Twitter: @aljax7.