What is an IPO?

An IPO, or initial public offering, generates a lot of investor excitement. But these stocks could be more hype than help to most portfolios.

When a privately-owned company is listed on a stock exchange and makes shares available to the public, it’s known as an IPO. To make an “initial public offering,” a company needs to meet the requirements of and file with the Securities and Exchange Commission (SEC).

The requirements for approval are extensive, and include creating a prospectus, which describes business operations, financial status, financial statements, and potential risks to investors. The SEC also examines accounting practices to ensure compliance with federal laws.

Once the SEC approves a registration, the company can list and sell shares on an exchange, like the Nasdaq or NYSE. Each exchange, however, has additional protocols for listing. In other words, going public is a lot of work for a company.

Here’s the critical part, though. A company doesn’t go public because management wants to expand the investor base to include you and me. An IPO is usually a liquidity event that allows early investors to cash out part, or all, of their investment. Or, it’s a capital raising event that will raise money to keep the business running (not the ideal scenario for new investors) or fund growth initiatives (much more compelling, in my opinion).

What does this mean for individual investors? First of all, buying IPOs isn’t that easy. That’s because brokerage firms generally reserve most shares for large institutions and the underwriting firms’ well-heeled clientele.

You may not want to buy an IPO anyway. After the IPO (initial public offering) event, there is often a period we refer to as the post-IPO blues. This is when the excitement of the IPO roadshow and big event has passed, and a stock settles down into real life as a public company. In general, this happens at some point in the first four months of trading, and after the initial IPO surge (which usually occurs on day one). The stock then trends down, often landing well below its IPO price.

This pattern happens over and over because it takes several quarters for everyone to understand the ebbs and flows of revenue and earnings, get comfortable with the company’s business model, and cozy up to management’s communication style. There is a relationship to build between a stock and its public investors. And that takes time.

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