by George Angell

I have a friend who has made a career specializing in a single type of investment – initial public offerings. IPO investing is a tailor-made for the small stock investor since so many new offerings come from companies just starting out. Such public offerings attract a special type of investor, the kind that doesn’t mind taking on substantial risk in pursuit of equally substantial profits. The rule in investing is that risk is commensurate with reward. In other words, you don’t grow rich buying T-bills. In the IPO world, the risk stems from lack of knowledge about a company since its track record may be thin and its trading record is often nonexistent. To borrow from Charles Dickens, the IPO is the worst of all investments and the best of all investments. It all depends on your perspective – and results.

In an IPO the company is typically poised to ramp-up its operations and enjoy a growth spurt. The reason for the IPO is that the company wants to raise capital for an exciting venture of some sort – one so special that the company’s owners are willing to give up equity for cash. Smart entrepreneurs, of course, keep a substantial portion of stock for themselves. That way, should the stock enjoy a surge in price after the IPO, they can become rich on rising share values. Not a few stock market fortunes have been earned in this fashion.

As with so many other things in the investment world, the IPO is a tradeoff for a small company. A privately-held company is free to more or less do what it wants with its assets. A publicly-held company, however, has obligations and restrictions placed upon its activities by regulatory authorities. In return for being able to offer shares to the public, the public company must publish quarterly and annual sales earnings results. It must follow strict rules set down by the Securities and Exchange Commission (SEC) regarding disclosure of the company’s activities. And it may be subject to the scrutiny of the company’s board of directors. It needs to hire independent auditors and attorneys to ensure that it complies with regulatory requirements. In short, “going public” is not something that any company takes lightly. 

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Why would an entrepreneur, who enjoys 100 percent of a thriving company, give up partial ownership via an IPO? The answer is very simple. Sometimes less is more. A smaller portion of the pie may be substantially more valuable to a CEO with the foresight to put the money raised in the IPO to good use. That’s why the capital raised in the IPO cannot be used simply to line the pockets of company executives. It must be put to work in a productive fashion. Thus, an offering is often contemplated when company executives find themselves faced with the dilemma of wanting to take on a project but in need of capital.

Wanting to grow the company via an influx of new funds, management must often make an important decision: Do they borrow the money or sell stock? One approach a company can make is to arrange private financing; another is to sell corporate bonds. Both have the pesky problem of having to repay the funds, however. In the meantime, the company has to pay interest on the loan. An alternative, of course, is to issue stock via an IPO. Should management then fall on its face, the shareholders lose out – not the company – since there is no obligation to ever repay them for their investment. By issuing shares, a company gives up equity in return for cash. For the investors, the payoff comes if the shares rise in value.

While IPOs are extremely popular among investors, there are also ways for companies to issue stock once they have already become public companies. They can issue more stock, known as secondary offerings. These offerings, too, provide much-needed capital to microcaps.

The drawback for the investor is that IPOs and secondary issues typically come with the least amount of information available to the investing public. At best, you are dependent on a legally-required prospectus and a road show put on by the company to highlight its potential. Since many of these deals are arranged privately, you may even have difficulty learning about an IPO because they are typically given only to high net worth individuals. Moreover, since corporate financing is often an insular world, information about a potentially lucrative IPO is often not even available to the average investor. This is unfortunate because some of these offerings are true opportunities which shouldn’t be missed. Nevertheless, as so often happens in the investment world, the rich get richer, buying and selling IPO shares.

Apart from disclosing in the prospectus accurate information regarding the use of the funds raised in an IPO, the company is under no obligation to perform to the satisfaction of shareholders. Even a cursory glance at virtually any prospectus for an IPO will reveal pages upon pages of disclaimers put there, no doubt, by the company’s attorneys. The disclaimers, therefore, state the risk of purchasing the IPO shares. The investor must be careful in investing in an IPO.

Not all IPOs are structured in the same manner. Some provide the company greater leeway in the use of the money. I once knew a couple of brothers, Ralph and Bill, who built up a very successful software company. Wanting to expand, they turned to public financing. In reading over the prospectus prior to the IPO, a friend remarked to me:

“This is a great deal,” he said, adding, “for Ralph and Bill.”

It seems they were offering a very small portion of the company at a relatively high per share price. Once public, the shares traded lower.

There’s a saying in the market that you can never really know a stock until you own it. So if you aren’t careful, your newly-acquired IPO shares might begin to resemble something less than a stellar investment. With a secondary offering, at least you often have a liquid market and a public history to rely on. But even this can have its drawbacks. Secondaries can likewise lose their liquidity once the excitement of the offering wears off. And, without liquidity, to whom are you planning to sell?