5 Essential Tips for Successful IPO Investing

There is money to be made in initial public offerings (IPOs), which mark the first time a private company’s shares are sold to the public and offer investors early access to potential growth. In the past, some tech IPOs delivered huge first-day gains, making it seem easy to profit quickly, but many of those companies, like VA Linux and theGlobe.com, ultimately disappointed.

Today, investors are far more cautious and focus less on a stock’s initial bounce and more on its long-term potential. Careful evaluation of a company’s fundamentals, business model, and competitive landscape has become essential before jumping in.

Getting Started With IPO Participation

First, to get in on an IPO, you will need to find a company that is about to go public. This is done by searching S-1 forms filed with the Securities and Exchange Commission (SEC). To partake in an IPO, an investor must register with a brokerage firm. When companies issue IPOs, they notify brokerage firms, who, in turn, notify investors.

Most brokerage firms require that investors meet certain qualifications before they participate in an IPO. Some might specify that only investors with a certain amount of money in their brokerage accounts or a certain number of transactions may participate in IPOs. If you are eligible, the firm will usually have you sign up for IPO notification services to receive alerts when new offerings pop up that match your investment profile. 

Should you decide to take a chance on an IPO, here are five points to keep in mind:

1. Conduct Thorough and Objective Research

Finding information on private companies planning to go public is tough, as they lack the analysts that public companies have. Remember that although most companies try to fully disclose all information in their prospectus, it is still written by them and not by an unbiased third party.

Search online for information on a company and its competitors, financing, past press releases, as well as overall industry health. Even though good intel may be scarce, learning as much as you can about the company is a crucial step in making a wise investment—or not. Your research might lead to the discovery that a company’s prospects are being overblown and that not acting on the investment opportunity is the best option.

2. Select IPOs Underwritten by Reputable Brokers

Try to select a company that has a strong underwriter. We’re not saying that the big investment banks never bring duds public, but, in general, quality brokerages are more likely to be associated with quality. It’s important to exercise extra caution when selecting smaller brokerages because they may be more willing to underwrite any company. Based on its reputation, Goldman Sachs (GS), for example, can afford to be a lot pickier about the companies it underwrites than a much smaller, relatively unknown underwriter can be.

One positive of boutique brokers is that because of their smaller client base, they make it easier for the individual investor to purchase pre-IPO shares—although this, as mentioned below, may be a red flag, too. Be aware that most large brokerage firms will not allow your first investment to be an IPO. Usually, the only individual investors who get in on IPOs are long-standing, established, and often high-net-worth customers.

3. Understanding the IPO Prospectus

We’ve mentioned not to put all your faith in a prospectus, but you should never skip perusing it. It may be a dry read, but the prospectus, which can be requested from the broker responsible for bringing the company public, lays out the subject’s risks and opportunities, along with the proposed uses for the money raised by the IPO.

For example, if the money is being deployed to repay loans or buy the equity from founders or private investors, it may be worth giving the IPO a miss. This isn’t an encouraging sign and tells us the company cannot afford to repay its loans without issuing stock. Generally speaking, money that is going toward research, marketing, or expanding into new markets paints a much better picture.

In addition, one of the biggest things to be on the lookout for while reading a prospectus is an overly optimistic future earnings outlook. Over-promising and under-delivering are mistakes often made by those vying for marketplace success, so it’s important to read projected accounting figures carefully.

4. Exercise Caution With IPO Investments

Skepticism is a positive attribute to cultivate in the IPO market. As we mentioned earlier, there is always a lot of uncertainty surrounding IPOs, mainly because of a lack of available information. Consequently, you should always approach them with caution.

That’s particularly the case if your broker recommends an IPO. When this happens, it tends to indicate that most institutions and money managers have graciously passed on the underwriter’s attempts to sell the stock to them. In this situation, individual investors are likely getting the bottom feed, the leftovers that the “big money” didn’t want. If your broker is strongly pitching a certain offering, there is probably a reason behind the high number of these available shares.

This should also serve as a reminder of another important point: it’s difficult for the average investor to acquire shares in a decent company about to go public. Brokers have a habit of saving their IPO allocations for favored clients, so, unless you are a high roller, chances are you won’t be able to get in.

5. Assess the Benefits of Waiting for the Lock-Up Period

The lock-up period is a legally binding contract, lasting three to 24 months, between the underwriters and company insiders that prohibits investors from selling any shares of stock for a specified period.

Take, for example, Jim Cramer, known from TheStreet, formerly TheStreet.com, and the CNBC program “Mad Money.” At the height of TheStreet.com’s stock price, his wealth on paper—in TheStreet.com stock alone—was in the dozens upon dozens of millions of dollars. However, Cramer, being a savvy Wall Street vet, knew the stock was way overpriced and would soon come down along with his personal net worth.

This overvaluation was noted during the lock-up period, though, meaning that even if Cramer had wanted to sell, he was legally forbidden to do so. Only when lock-ups expire, are the previously restricted parties permitted to sell their stock.

In theory, waiting until insiders are free to sell their shares is not a bad strategy because if they continue to hold stock once the lock-up period has expired it may be an indication that the company has a bright and sustainable future. During the lock-up period, there is no way to tell whether insiders would, in fact, be happy to take the spot price of the stock.

Let the market take its course before you take the plunge. A good company is still going to be a good company and a worthy investment, even after the lock-up period expires.

The Bottom Line

Successful companies regularly go public, yet sifting through true long-term opportunities from hype takes work. Smart IPO investors dig into objective information about the business, its competitors, and its industry, pay attention to the quality of the underwriter, and read the prospectus closely to understand both risks and potential.

They stay skeptical of IPOs heavily pushed by brokers, often a sign that institutions passed, and may even wait out the lock-up period to see how insiders act once they’re free to sell. In the end, patience, caution, and informed analysis tend to outperform blind optimism.