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Deep Philosophy and the IPO
Linda Goin
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Vacation is relaxation time. It's kick-your-feet-up time, with your hand wrapped around a cool glass of whatever, and space to converse amicably with friends and family. A good conversation on theory and logic peppered with personal opinion goes well with a nighttime river, lightning bugs, and a few wary deer. These talks usually end with laughter or mutual shrugs, and no one walks away with trophies or loser's bruises.
This is the sort of conversation my brother and I crave. We don't get the face-to-face opportunity often, but each chance is great for the soul. During this vacation, Cora was deemed mature enough to join us on our philosophical trips to the river. She listened as we rambled on about various topics. She couldn't do much else, as her uncle had stripped the batteries from her GameBoy.
It was during one of these deep discussions when the topic of small business and innovation came up - IPO's in particular. Cora wanted to know what an IPO was, and my brother told her it was an Initial Public Offering. When I asked Cora what she thought this meant, she responded, "It means someone signs initials to a paper so a business can pass a collection plate." Her statement was made with such certainty that it took a minute for it to sink in. After we laughed, and assured Cora she wasn't that far off, we tried to explain the IPO to her.
Basically, this is how an IPO works: A business - let's say it's the ABCD company - decides to go public. This means the company wants to offer shares of stock in their business on the market. ABCD has a number of reasons to go public to raise funds. They want to eradicate debt, they want to acquire new assets to grow their business, and they want to pave the way to acquire more funds in the future, among other reasons.
First, ABCD selects an underwriter. An underwriter is a brokerage firm that raises money for ABCD. They act as middlemen, as they purchase stock from ABCD to sell to the public. The SEC (Securities and Exchange Commission), and the National Association of Securities Dealers (NASD) regulate this process.
During this process, ABCD files its IPO with the SEC. ABCD then collects information for a preliminary prospectus. This document contains a description of ABCD's products or services, strategies for the future, a presentation of historical financial statements, explanation of recent financial situation, the management (and board, if applicable), and their backgrounds.
The preliminary prospectus needs to be meticulous, as this is the only representation ABCD will have before the IPO debuts on the market. Management, board members, and underwriters aren't allowed to talk about anything beyond information represented in this document.
When ABCD announces a launch of its IPO, the following action resembles a political tour. They schedule breakfasts, lunches, dinners, and any other event with free food as they wine and dine representatives of large institutional investors. These are the pockets ABCD wants to win. ABCD wants their approval, because high institutional investment interest means a possible higher price on the initial market offering. If ABCD is a popular company, they could attract hundreds of investors to each event.
ABCD's road show popularity helps management and their underwriters set a price to launch the initial equity sale. This price is based on the tenet of supply and demand; however, the supply is usually reserved for large institutional investors. Individuals who trade frequently might get in on the IPO, but it can be difficult, due to the underwriter's need to secure commissions and to push ABCD to the max among institutional investors.
IPOs might sound like a great deal, but they're very risky. IPOs are risky because they don't have public track records, they don't have the advantage of analyst ratings (although relying on those can be just as risky), and they often change business plans as they go through initial rapid growth after the public offering.
Another reason IPOs are so risky - especially during the first couple weeks - is because of the in-grained habit of some investors to flip. No, flipping isn't acrobatics over the thrill of owning IPO shares. Flipping is the practice of buying shares in an IPO expressly for the purpose to sell them immediately in the aftermarket (the day the stock actually trades on the market). Small investors often make a habit of this practice, but large institutions might also want to see immediate profit. Buyers usually crawl all over sales of new stock on first day trading. This is a great time to sell for a point or two, especially for those who own large blocks of IPO shares. Underwriters don't like this. Neither does ABCD, as they want a strong entry with a steady rise in price.
The upside to letting shares go immediately is liquidity for the smaller investor. The downside is the action - and the price - might fall over the next few days as the dust settles. It's very difficult to make a profit on the purchase of flipped shares. The fun in flipping is watching the action, especially when your money isn't involved in the fray. The action resembles a fish feeding frenzy.
On the other hand, we've all heard about folks who bought into Coca-Cola some umpteen-years ago and who live in high fashion today. We've also heard of the Microsoft investors who bought shares directly from Bill Gates when he only had one set of clothes. IPOs can be exciting. They can also be a great source of news in various market sectors. Even though BUYandHOLD doesn't offer IPOs, it's still a great idea to stay on top of IPO news. You never know what you might learn about the future through fresh company offerings.
Well, this is about where we'd yawn, stretch, and decide we've talked enough for one night. Time to rest and watch the lightning bugs, bright as Venus setting on the horizon.
Until Next Week,
Linda Goin
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