What You Need to Know About IPOs

IPOs. Let’s talk about that. Today, after a record high in 2020, the market is still in a frenzy around IPOs especially after the latest news from Coinbase – the IPO that some were saying could be the most valuable after Facebook. 

In 2020, There were 480 IPOs on the US stock market, an all-time record. Across the world, many more. Some you know, some you have probably never heard of: Warner Music, Li Autom, Snowflake, Airbnb… It was an increase of +106.9%  from 2019. It is also 20% higher than the previous record IPO year of 2000 preceding the dot-com bubble. There has been debates on whether there was a correlation between the two, we will discuss this later down

Fast forward to this week. You might have heard about Coinbase, a San Francisco startup that allows people to buy and sell digital currency. 

It was founded in 2012 by Brian Armstrong, a former Airbnb software engineer when he became frustrated with the services provided for overseas digital transactions. He joined forces with former Goldman Sachs trader Fred Ehrsam. Together they founded Coinbase. According to them, the mission was to disrupt the global financial system and demystify crypto for the masses. They wanted to make it easy for everyone to buy and sell cryptocurrencies without having to go through a bank. With Revenues around $1.3 billion in 2020, many retail investors would say it performed really well and were very excited about the potential.

Coinbase just became the first major cryptocurrency company to IPO. Trading opened at $381 a share on Wednesday bringing the company’s valuation to around $100 billion – almost what Facebook was worth at its IPO in 2012. Experts are saying that this shows that Wall Street is warming up to the idea of cryptocurrency.

And people are talking about it. 

First, let’s dive a bit. So, what is an IPO?

IPO or Initial Public Offering is the process of offering shares of a private corporation to the public by issuing new stocks. This allows the company to raise capital from public investors. It is an important milestone for companies as well as initial private investors. The process allows them to gain from their initial investment since it usually includes share premiums. At the same time, public investors join in on what is typically considered a success story. Companies IPO for different reasons. 

Raising capital: This is probably the main reason. Companies sell shares so they get money and at the same time, give investors a ‘promise’ of future earnings. It is a great way to get funding. Companies need money to grow, hire more employees, innovate and develop new features, services, and products. 

Raising interest and brand equity: A big event is like a big stamp of success and validation of all the hard work. It generates media buzz and positive public perception (if all goes well) which leads to also generating interest from institutional investors. Because public companies are put under a proverbial microscope that private ones aren’t, the public trusts the information they release. 

What are the consequences?

IPOs reward Early investors, whether they are private individuals or venture capitalists that believed in the company’s future from the get-go. Sometimes, some investors already plan years ahead for that moment. But it is not only investors that benefit, employees are also rewarded. If you are in the region, you might have heard of Anghami’s IPO. When you work for a new company, you are not necessarily paid a lot of money, but you are given shares. This gives employees a sense of ownership and a sense of working towards a big success story. When a company goes public, founders, investors, and employees get paid for their early faith.

How do you get to the IPO milestone?

Typically, there are 5 main steps to get to an IPO. The process starts with finding a bank to advise the company and provide it with underwriting services. We call it the underwriter. For the US, it is generally a Wall Street Bank – such as JPMorgan Chase. 

The second step is the Due Diligence one, where the underwriter acts as a broker between the issuing company and the public. This is when the number of shares that can be offered is determined at a certain price. The underwriter sits with the company’s management team and stakeholders to finalize the paperwork and regulatory filing. They put together a statement that has all information on the company’s KPIs and financials. 

The company and the underwriter will then approach institutional investors around the globe in what is technically referred to as a Roadshow. The feedback collected will confirm the price and the number of shares to issue. These investors confirm their commitment to participate via engagement letters.  If you are familiar with startup fundraisers, this is quite similar to that part. 

The value of the share is generally estimated and the price set is a bit lower, so initial investors can have a chance to sell to the secondary market since they usually take the risk. 

Once that is done, the authority body approves the IPO and a date is set. 

What do you need to keep in mind as a retail investor?

IPO investing isn’t a simple affair. The secondary market selling price and the face value price have a good difference between them. This is called the premium. 

If the company already has a lot of hype around it, the demand price is usually due to the people excited about it. Generally, IPOs are sold out by the time they hit the floor. The company stakeholders and initial investors, and the big institutions’ network get the first seat to the show. If it’s a great IPO, the shares are all gone by the time it is public. 

So when you come to buy as retail investors, you could be too late already. You can buy only at a price that is higher. That is also how large institutions make a lot of money usually. They flip the stock they bought and make a profit. It is the nature of the business. 

Today, IPO pricing is not only a function of the company’s net worth and earnings but also a pricing and marketing strategy. 

So when would you come in? Well generally, retail investors should not go for IPOs that are highly priced without accounting for a company’s strong fundamentals. Same as when you want to buy stocks: you think that generally, the future value is greater than the current one. Keep in mind that this falls into the bucket of speculation. Investing in winning IPOs is like buying a lottery ticket. 

Academic research shows that we as retail investors are bad at picking winners. IPO winners are not any different – if not more difficult since you don’t have the historical performance. 

You should know that 80% of the IPOs tend to fail. 2019 for example was a year of IPO disappointment. 60% of them had negative returns after 5 years in the secondary market.  Lyft’s share for example soared 9% at its debut, then fell 12% on the second trading day to below IPO price. It has struggled to go back ever since. This is the ‘timing the market’ strategy we always tell you not to do. 

Another thing to keep in mind is the lock-in period in certain markets which sometimes is around six months after the offering, where insiders can’t sell on the open market. This is supposed to prevent them from selling too quickly.

So what do you do? Again, we go back to fundamentals. You could potentially do what these institutional investors do: Look into companies’ public records or statements that precede the IPO – how the company is making money and what are its future plans. If this is too overwhelming for you, then you probably should not even consider going there. 

So, you may be asking: what’s the conclusion here? Should you never buy shares in a company that IPOed? Well, the answer can be simple. Some of these companies might already be in your own Sarwa Invest portfolio – like Etsy in the VTI ETF for example. If there is an IPOing or IPOed company out there that you are truly excited about and it aligns with your beliefs, make sure you invest money you are comfortable losing. The story could be an exciting one, but make sure you also have an emergency fund and a diversified long-term portfolio of investments for the bulk of your wealth.