By Brittany N. Cox,
Registered Investment Advisor at Nestlerode & Loy Investment Advisors
With the recent launches of Zoom, Pinterest and Lyft, there has been a lot of news about stock IPOs. An initial public offering, or IPO, of a stock is a company’s first sale of stock to the public. Before there is an IPO, a company is considered private. A private company has a small number of shareholders such as founders of the company, owners, family and friends. However, when a company goes public, shares of the company can be bought by anyone including individual investors or institutional investors.
This reminds me of the NFL Draft that is going on as I write this article. The college players resemble private companies when they are playing their college career as unpaid athletes. Now, they are entering the draft and “going public” where they will raise large sums of cash from investors. The investors relate to the teams and organizations choosing which players they think will perform the best. The individual investors choose the companies which they feel will perform the best and increase their value.
Having a private company means that most things about the company can be kept private. However, once the company goes public, it forfeits some of its privacy. For example, a private company is not required to disclose much of the financial and accounting information regarding the business, but a public company must publish annual reports to shareholders and even make some of the financial data public information. A private company is easy to start and doesn’t require a large cash reserve. Generally, when you think of private companies you think of small to mid-size businesses. However, some large, well-known companies are private such as Ikea, Staples, Wegmans, Petco and Sheetz.
Public companies usually have thousands of shareholders and have strict rules and regulations on the company. They must have a board of directors, report financial and accounting information each year for auditing, and must follow the rules of the stock exchange that their company shares are traded on. The owners lose much of the control of the company as the ownership is split up among thousands of shareholders verses being previously held by a few private owners or investors. The cost of regulation and management is very large for a public company with the added reporting and regulation.
So, with all these requirements and regulations, why would a company want to go public? While there are many ways for a company to acquire funds such as loans, private investors, or even being bought out by another company, the sale of shares during an IPO raises a substantial amount of cash for the company.
Facebook is one of the largest IPOs to date. When the company went public in 2012, it raised $16 billion. That is a pretty large sum of funds to grow and expand a company. Also, public companies are usually offered lower interest rates on debt they issue. They are even able to offer more shares of stock in a “secondary offering” later. A public company is also viewed by the public as a more prestigious company and usually gives them a more positive image which in turn helps sales and profits.
As an individual investor, is there a benefit to buying an IPO on a stock? It depends. I mentioned the Facebook IPO which is one of the largest ever, it is also important to know that it took Facebook a full year after its IPO in 2012 to hit that IPO price again after falling for months. Another example was Snap in 2017, which was coined the “hottest tech IPO in years” and sunk to its lowest price ever a year later in 2018. An article by CNBC published April 22 states that “more than 60% of the 7,000 plus IPOs from 1975 to 2011 had negative returns five years following their first trading day and only a few produced extreme positive returns,” according to UBS analysis using data from University of Florida professor Jay Ritter.
Analysts such as Eric Walters suggest a few reasons for an initial period of unforeseeable trading are due to corporate insiders selling shares, the company working on functioning as a public company, and people looking to create short term gains in IPOs who sell off quickly. The media tends to create a big hype around an IPO, enticing investors to jump in. Then many of those investors sell off quickly creating dramatic spikes in the price of the stock. If you find a company that you really feel is a good pick for you and you believe they have a solid future, you still may want to consider waiting out the dips and initial period of trading before buying in. Just as some teams will let players go into free agency after the draft and wait for them to show signs of improvement, you should consider letting stocks be free agents for a while before buying in.
Nothing contained in this article should be interpreted as a promise or guarantee of earnings or investment results nor a recommendation for the purchase or sale of any security or sector.