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An IPO (Initial Public Offering) marks a private company's transition to a public company. You invest in IPO once shares begin trading on an exchange.

With the hype surrounding Robinhood’s initial public offering, we thought it’d be a good time to review the basics of how an IPO works.

An IPO can be an attractive investment opportunity. But before you invest in one, it’s important to understand how the process of trading them differs from most other types of investments, as well as the unique risks associated with this type of investment.

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Initial Public Offering (IPO) Explained

Think of an IPO as a type of exit strategy for early private investors, and a means for the company to raise additional capital from the public market. It is the mark of a transition from a private company to a newly minted public company traded on an exchange.

This requires publicly disclosing financial statements and adhering to the much stricter regulation of the Securities and Exchange Commission (SEC), which private companies are not subject to. During the IPO process, a company will file the initial registration form required for any new security containing important information about the company. It is meant to serve as the key source for due diligence, along with the prospectus available to potential investors.

Read More: Stock Options: What Are They and How Do They Work?

How Does It Work?

Once a company decides to go public, they start by hiring an investment bank to facilitate the process. The deal can be structured as either a firm commitment where the investment bank agrees to buy the entire offering at a discount and resell it to the public, or on a “best-efforts” basis. Here, the bank just brokers the deal and sells the shares directly to the public with no guarantee to the company.

Typically, the top investment banks underwrite an IPO on a firm commitment basis. Usually there is a kind of bidding process amongst different banks and the company will choose one or more investment bank(s) to serve as the underwriter(s), with one bank serving as the lead underwriter.

The lead underwriter leads the syndicate of the selected banks (created to spread risk across multiple entities) and market the offering. They go on roadshows to market the shares to institutional investors, gauge interest and hype up the offering. For the most part, retail investors will not be able to participate at this stage and can only invest in an IPO once shares begin trading on an exchange.

The spread between the IPO price (the price at which shares begin to trade in the open market) and the offering price (the price at which the company offers shares to investors) is what makes up the investment banks’ profit. When there is more demand for an IPO than the number of shares offered, it is considered “oversubscribed,” which creates even more hype around the offering. There is typically a good amount of volatility when a new stock begins trading as part of the price discovery process that balances supply and demand.

Read More: How Katie Z. Leveraged her IPO Equity to Buy Her First House at Age 28

Should You Invest in IPO Stock?

If old adages are to be believed—the early bird gets the worm. But sticking your beak blindly in every dark hole you see could be a risky endeavor. So exercise some patience and caution if you are an early investor going for that worm!

The reality is that typically, only institutional investors and the top clients of full-service brokerage firms have access to shares of hot IPOs at the offering price. If you are an everyday investor, you would instead buy shares on the secondary market (or the stock exchange). If the IPO is highly successful, shares may rocket past the offering price on the first day of trading, which is good for initial investors, but dicey for those buying on the secondary market.

Before buying a high-flying new stock, consider the basis for its share price. Because there is minimal information available, new IPOs trade mostly off investor speculation and not fundamentals. There can be especially high volatility in the first few days of trading because the stock goes through an initial period of price discovery (the process of setting the proper price of a security) in the market.

After the initial frenzy, it’s not uncommon for the new stock to settle at a lower price, at least for the time being. But if you plan to buy early before the company has any sort of established track record, be aware that the wild ride could continue for the foreseeable future.

When to Buy In

If you are interested in the long-term prospects of the new company and you can muster some patience, it’s probably best to consider waiting at least until trading has settled down and more objective information is available on the company’s financials and market prospects.

For those with just a little patience, one relatively fast milestone is the expiration of the “lockup” period, or a window of time where investors are not allowed to redeem or sell shares. This means that company insiders can’t sell the stock they were issued until a specific amount of time after the IPO. This period is usually between 90 and 180 days, but a little research will help you learn the exact agreement for a specific company.

After that period ends, watch what happens. If insiders are selling like crazy, it may be an early indicator that the stock is overpriced (or at least insiders think so) or that there are other potential red flags around the company’s long-term prospects. This doesn’t always mean danger, as insiders may sell for liquidity reasons or to decrease their concentration risk. However, it’s best to proceed with caution in this situation.

The most prudent approach is to wait until there is enough public information available to make a more informed decision. IPOs do include a prospectus, which provides valuable financial details, the company’s anticipated risks and opportunities, and information about how the money raised will be used. While this information is helpful, it’s a pretty skinny body of research compared to the material available on established public companies. However, that body of research will grow quickly as more analysts begin to follow the new company and it makes mandatory SEC filings.

Wait for the details to emerge. A quality company most likely has decades of growth ahead—and the trajectory will not be straight up—so there will be many opportunities to invest.

Key Takeaways

The idea of making a fortune with a one-time investment in an IPO sounds exciting. But investing is a long-term game. Focusing on investing in a diversified portfolio filled with quality companies is the more prudent path for most investors.

Investing in untested companies is simply an unnecessary risk. But if you do decide to dabble, make sure you understand the risk and keep it to a very small portion of your portfolio.

You can keep a close eye on your investments using the Personal Capital Investment Checkup. Millions of investors use this free tool to:

  • Evaluate investment performance
  • Compare current portfolio allocation to the ideal target allocation
  • Meet their long-term financial goals

The Investment Checkup is part of the award-winning suite of tools for managing all of your financial accounts in one place. Want to take control of your financial life?

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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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