IPOs

In short

A friend of mine once asked if she should stay up past midnight to get shares in a hot new company on its first day. I told her what I will tell you. An IPO is a company selling its stock to the public for the first time, and the price you see on opening morning may not be the price you can get. If you are holding a brokerage account, you can ask whether it offers access to new issues and what it requires. Read the prospectus first, because that is the document the company files with the Securities and Exchange Commission. Look hard at the fees, the lockup rules, and how the company says it will use the money. Decide how much you could lose without losing sleep. Then act only on your own plan.

The whole of it

What it is

I once watched a neighbor sell his hardware store to a younger man, and the whole street gathered to see the sign change. An initial public offering works something like that, only the buyers are strangers across the country. A private company decides to sell shares to the public for the first time, and its stock begins to trade on an exchange like the New York Stock Exchange or Nasdaq.

You have probably wondered why a company would bother. The answer is plain enough. It wants money to grow, to pay off debts, or to let early owners cash out some of what they built. Founders, employees, and early investors often hold shares that cannot be sold on the open market until the company goes public.

Going public also changes the rules. The company must file regular reports with the SEC and share its finances with anyone who cares to read them. That openness is the price of admission. It is also a gift to you, because it means the facts are on the table if you are willing to read them.

How it works

A story helps here. Picture a young company called Maple Street Software that decides to go public. It hires investment banks, which are firms that help sell new shares. These banks are called underwriters. They study the business, help set a price range, and line up big buyers before the shares ever trade.

The company files a registration statement with the SEC. The main part of it is the prospectus, and it lays out the business, the risks, the finances, and who gets paid what. Underwriters then take the company on a road show, which is a series of meetings with large investors who might want shares.

Here is the part that surprises people. The offering price is set the night before trading begins, and the first shares usually go to big institutions and favored clients of the banks. By the time the shares open for ordinary trading, the price may already have jumped or dropped. Many everyday investors are not buying at the offering price at all. They are buying on the open market at whatever price the crowd sets.

Some brokerages let customers ask for shares at the offering price, but they set their own rules and limits. Getting shares is never promised. You may ask for a hundred and receive none.

There is one more thing to know. Insiders are often barred from selling for a set stretch after the IPO. This is called a lockup period, and the length is spelled out in the prospectus. When it ends, a wave of new shares can become available to sell. Watching for that date is part of understanding the story.

The numbers, and where to find yours

You will want a few figures in front of you, and the good news is that most of them are free to read. Start with EDGAR, the SEC's public database at sec.gov, where every prospectus is filed. Search the company name and look for a form called an S 1, which is the registration statement for a first time offering. The final prospectus comes later, often as a form called 424B4, and it holds the final price.

Inside the document, find the price range and the number of shares offered. Multiply the two and you have a rough idea of how much money is being raised. Look at the underwriting discount, which is the fee the banks take, and the section called use of proceeds, which says where the money is going. Check the revenue, the losses, and the debt. Look at the risk factors too. They can feel like a long list of worries, but the company is required to be honest there.

Two tax and account facts may touch you as well. Gains on stock you sell are taxed differently depending on how long you held it, and the IRS explains this on its pages about capital gains. The rule that decides what counts as a long term holding is set by law, so check the current figure at the current figure, which the official source publishes each year. Any limits that apply to your own account type come from the rules of that account, so ask your brokerage and read its disclosures.

A worked example

Let me tell you about a woman named Dolores, a school bus driver with a small brokerage account. She heard that Maple Street Software was going public and got curious. She did not ask whether to buy. She asked what it would cost her to find out how it all worked.

She pulled up the S 1 on EDGAR and found a price range of 18 dollars to 20 dollars a share. She noticed the company planned to offer 10,000,000 shares. Using the top of the range, she multiplied 10,000,000 shares by 20 dollars, and got 200,000,000 dollars. That was the most the company could raise from the sale, before fees.

Next she looked at the underwriting discount, which the prospectus listed at 7 percent. She worked it out the plain way. Seven percent of 200,000,000 dollars is 0.07 times 200,000,000, which equals 14,000,000 dollars. Subtract that from 200,000,000 dollars and the company keeps 186,000,000 dollars, before its other expenses.

Then Dolores did a small test on her own money, just to see the shape of it. Say she had asked for 50 shares at 20 dollars. Fifty times 20 is 1,000 dollars. If the stock opened at 26 dollars, those 50 shares would be worth 50 times 26, which is 1,300 dollars, a gain of 300 dollars on paper. If it opened at 15 dollars, they would be worth 50 times 15, or 750 dollars, a loss of 250 dollars. She saw that the same 1,000 dollars could land in two very different places by lunchtime.

She also saw that most of her chance of getting the offering price depended on her brokerage, not on her. So she wrote down the lockup date from the prospectus and a note to read the risk factors twice. She did not buy anything that day. She simply understood the road she was looking at, and that was worth the afternoon.

Where it goes wrong

I have seen smart, careful people lose their footing around a shiny new listing. The first stumble is chasing the excitement. A famous name and a loud news story can make a company feel safe when the numbers say otherwise. Many new companies have never turned a profit, and the prospectus will tell you plainly if that is the case.

The second is mixing up the offering price with the trading price. If you hear that a stock doubled on its first day, that gain went to whoever got in at the offering price. You may be paying the doubled price. Do not feel foolish if this confuses you. It confuses plenty of folks.

Third, the lockup. When insiders can finally sell, extra shares may come to market. Not reading that date leaves you guessing about something the company already told you.

Fourth, putting too much of your savings in one new name. A single company is a single bet. Fees and taxes add up too, and a quick sale can mean a bigger tax bill than a long hold. Check the IRS pages on capital gains before you act.

Last, trusting a tip. A coworker or an online post is not a prospectus. Read the source yourself. Doing that is a quiet act of respect for your own hard earned money.

Questions to answer before you leave this page

Have you found the company's S 1 on EDGAR and read the risk factors with your own eyes? Do you know what the company plans to do with the money it raises? Can you say in your own words how the company earns its living and whether it has ever made a profit? Do you know the lockup date, and what might happen when it ends? Have you asked your brokerage whether it offers shares at the offering price, and what it would charge you? Could you lose the whole amount you are thinking about and still pay your bills and sleep well? And if you walked away today and bought nothing, would that be a perfectly good decision too?