Initial public offerings (IPOs)

Initial public offerings (IPOs)

Initial public offerings

Buying stocks with borrowed money is usually one indicator of stock market mania. A lot of initial public offerings is another.

An initial public offering, or IPO, is obviously the first large-scale sale of stock in a company to the public at large. Before the IPO, a company sells shares to early investors like the founder, the founder's family and friends, and then to a limited number of outside investors like venture capitalists.

However, as the company grows and requires more capital, the company needs to attract more investors in a number of different states. This means that the company has to register with the Securities and Exchange Commission and do an initial public offering.

Underwriting IPOs

When a company makes an IPO, it normally hires investment bankers to underwrite the sale of stock. The underwriters promise to buy all the stock that the company will issue. Then the underwriters turn around and sell the stock to pension funds, mutual funds, and individuals.

Why founders take the company public

Initial public offerings are attractive to the early investors, and are often popular with the general public. The early investors gain because the IPO offers them liquidity. At the start of their venture, the founders and others may have invested hundreds of thousands of dollars into the business.

By taking the company public, the early investors see the dilution of their ownership share, but they now own negotiable shares in a larger company.

IPO flipping

Initial public offerings also can be a good deal for the general public. The easiest way to make money through an IPO is to "flip" the shares. Flipping involves the purchase of the new shares directly from the underwriter, and then selling them immediately in the open market.

Typically, the stock price set by the underwriter is set somewhat below the true value. The underwriter's price is a compromise for the company because the existing owners want the maximum value for the share of ownership that they're giving up, but they also want to sell all the shares.

Here's an example of how to make money by flipping IPO shares. The underwriter sets the IPO price at $20 a share. The IPO is for a popular company, so you know you can turn around and sell the shares on the open market when trading begins for perhaps $22 a share.

So you buy shares from your buddy, the underwriter, and then turn around and sell the shares in the market for the expected $2 gain. A 10 percent gain in one day is a good way to make money.

Individuals can't get into good IPOs

Still, flipping isn't a foolproof way to make money with stocks. First, the vast majority of individuals won't be able to buy stock directly from the underwriter.

The underwriter generally will save the best IPO companies for the large institutional investors or others who give the underwriter a lot of business.

So normally, if a broker gives you a call and gives you a long-winded account of a super IPO that he'll let you in "on the ground floor", you may want to follow the old adage and, "Never buy anything from someone who's out of breath." Chances are this is a dog of an IPO that the large institutions don't want anyway.

Buying and holding good IPOs

However, in addition to flipping shares, you also can make money by buying and holding a successful initial public offering. Just think, if you had bought into Microsoft when it came public, you would have made a small fortune by now.

Unfortunately, IPOs like Microsoft are few and far between. In fact, a number of studies show that, on average, IPOs underperform the market. For every Microsoft there are several companies that go bust.

IPOs are exciting and offer a lot to entrepreneurs and early investors, but individuals should steer clear of them.