What is an IPO?
An initial public offering (IPO) is when a privately owned company offers shares to the public for the first time. The aim of this process is for the company to raise capital, which can then be used to expand, pay off any existing debt and provide a payout to the original shareholders and early investors.
A company wanting to undertake an IPO will use an investment bank to help them decide how many shares to offer and at what initial price. It will oversee the process that culminates with the company having shares listed on a stock exchange, which can then be bought by traders and investors.
The idea for investors is you can buy shares in a company during the IPO and then trade them on the secondary market after they are publicly listed. There is the potential for upside gain at a rate rarely seen for companies already on the stock exchange, but there is also inherent risk too.
Advantages and disadvantages of investing in an IPO
The central appeal of investing in an IPO is the fact it could offer higher-than-average growth. In the first instance, IPOs are often priced at a discount to help boost initial sales, which means there is more chance for upside gain.
The downside is there generally isn’t as much data available with an IPO as with a more-established company, which makes it more difficult to research it. That said, there is a prospectus released when the company announces its intention to float, which includes performance data and details of any factors that could impact its future growth potential. There is, however, arguably still far greater risk in investing in an IPO than an existing company with a visible track record, particularly when IPOs can often perform out of line with expectations. While some companies' IPOs can lead to a rapid rise in share prices, there have been a plethora of big names whose shares have ended up falling in value after their first day of trading.
How to invest in an IPO
Invest directly with the company
In some instances, a company will make its IPO available to the general public. This is often the case with formally nationalised companies - for example, the Post Office. However, for the majority of companies, they are more interested in attracting institutional investors, as they will invest a greater amount.
In cases where the company does encourage everyday investors to participate in the IPO, you can simply invest in them directly, without having to use a third-party broker.
Invest through a broker
Although it isn't a feature offered by every investment platform, some, including Hargreaves Lansdown* and AJ Bell*, allow investors to participate in IPOs before they become available on the main market. In this instance, you will need to follow these steps:
- Open an account with that platform
- Use the platform's IPO search function to find upcoming IPOs. Alternatively, you may be able to receive notifications of when IPOs are happening
- Register your interest in an IPO and state how many shares you wish to buy
- Make sure you have sufficient funds in your account to make the purchase
- Wait for the shares to be transferred to your account
- Choose when you want to trade the shares on the secondary market once they go public
There is also the option to invest through an app specifically dedicated to IPOs, PrimaryBid, which is designed to give the public easy access to IPOs, at the same time and at the same price as that enjoyed by institutional investors.
Invest in the secondary market
If you aren't able to access the IPO before it becomes publicly listed, you can opt to invest in the secondary market from the day it goes public onwards. You can do this through a trading platform, such as Freetrade*, eToro or Plus500, which can generally give you access to the shares as soon as they become available on the stock exchange.
Investing in IPOs vs crowdfunding
Crowdfunding is becoming increasingly popular, with many start-ups and young businesses using it as a way to raise capital. It differs from an IPO in as much as it doesn't mean the company is listed on a stock exchange. Additionally, the aim of crowdfunding is to get lots of people to contribute a relatively small amount, rather than seeking substantial contributions from a set number of investors, including large, institutional investors.
Crowdfunding works in one of the four main ways:
- Donation crowdfunding - donating money because you believe in the cause, with no financial or other tangible gain
- Reward crowdfunding - donating and receiving a reward, such as the product or service the company produces
- Debt crowdfunding (peer-to-peer lending) - lending a company money, with the understanding it will be repaid at a set point in the future
- Equity crowdfunding - investing in exchange for a stake in the company, for example future shares or other securities issued by the company
The advantages of crowdfunding are that it is quick and easy to do, with would-be crowdfunders typically able to complete the process online with the click of a button, as well as only requiring a small initial outlay. Many crowdfunding campaigns are happy for backers to put in anything from a few pounds upwards, compared with IPOs, which require a larger minimum investment.
The main disadvantage of crowdfunding is the risk involved. Working on the basis that the majority of start-ups fail, there is a much-higher-than-average chance that you could lose some - if not all - of your money. Even if you don't lose your money, it is often unclear when you'll see a return on your investment and how much it is likely to be. With this in mind, it makes sense to opt for a company that you believe in or are excited by and, vitally, not put in too large an amount.
Summary: IPOs and crowdfunding
Investing in IPOs and crowdfunding both offer the opportunity for investors to benefit from the unrivalled growth potential in fledgling companies. The drawback is the higher level of risk involved and, although both IPOs and crowdfunding are regulated, the relative lack of transparency compared with more established companies.
While crowdfunding typically happens in the very early stages of a business' life, an IPO happens at the point it is breaking into the mainstream and the processes it has to go through before it is officially listed on a stock exchange means there is a greater amount of information available to give investors a better idea of what the potential risks are. It is, however, more difficult for everyday investors to participate in IPOs compared with crowdfunding.
As the risks for both types of investing are higher than with other investment types, it's a good idea to seek financial advice before partaking in either IPOs or crowdfunding and, as always, never invest more than you can afford to lose.
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