Investing in an initial public offering (IPO) has gained a lot of popularity in recent years. With many private businesses deciding to go public, a lot of excitement has built up among investors surrounding these new opportunities.

But is investing in an IPO actually a good idea? And what are the risks involved? Let’s take a closer look.

What is an IPO?

An IPO is one of several ways a private business can go public and list its shares on a stock exchange like the London Stock Exchange. Another alternative method that’s gained traction recently is through a reverse merger with a Special Purpose Acquisition Company (SPAC) or by direct listing.

IPOs attract a lot of media attention. And due to deliberate pricing tactics, the media hype and investor excitement often result in the share price quickly rising in the first few days of trading as a public stock.

This is why investing in an IPO is often a popular strategy. However, all too often, the initial momentum tends to slow down. And in some cases, a thriving IPO stock can quickly turn into a falling knife.

That’s why it’s critical to understand how this process actually works, the underlying business, and the risks to consider before making an IPO investment decision.

How does an IPO work?

When a private company plans to go public through the IPO process, it first hires an underwriter.

The underwriter is usually an investment bank like JP Morgan or Morgan Stanley. They consult about valuation, setting an initial price for the offering, and making all the necessary preparations for the big day, including what’s called a Roadshow.

A Roadshow is a series of events to build up interest in the professional investing community. That way, before a business goes public, the firm already has a lineup of institutional investors ready to buy shares.

At the end of the expensive process, the company’s shares are listed on a selected exchange, the opening bell rings, and the stock market welcomes a new business, either positively or negatively.

Given the hassle and cost involved with going public, why do companies do this? There are three primary reasons:

• To raise additional capital.
• Attract mainstream media attention to the company.
• Being a public limited company makes it easy to secure additional funding in the future.

Investing in an IPO

Purchasing shares in an IPO is a bit different to normal investing practices. And for a retail investor, it’s usually not actually possible to buy IPO shares until after they’ve hit the stock market. At least, not through a standard trading account.

Thanks to technological innovation, there are specialist brokers available today that handle IPO orders from retail investors, lowering the barrier to entry.

However, typically the privilege of buying pre IPO shares is reserved for large institutional investors like hedge funds. And the transactions occur before the stock is even listed on a publicly traded exchange.

One critical difference to be aware of between standard investing and IPO investing is the Lock-Up Period. When shares are purchased at the IPO price, the transaction is conditional. And often, investors won’t be able to sell or redeem their shares for several days or even weeks after the shares are listed on an exchange.

During that time, the share price could move up or down. And it’s entirely possible to be left with shares that are worth considerably less than the original purchase price with no ability to sell until after the Lock-Up Period has expired.

For an individual investor buying shares after they have been listed, this Lock-Up Period doesn’t apply. But often, once it expires, financial institutions tend to sell their positions for short-term gains, potentially triggering a sharp sell-off. That’s another risk to be aware of.

Pros and Cons of investing in IPO

Many investors consider investing in an IPO akin to speculation, suitable only for short-term traders.

As a long-term investor, there are quite a few undesirable aspects to participating in these types of transactions. First and foremost is a lack of information.

While a company going public will file an S1 form, similar to an annual report to explain what the business does, these documents tend to be over-glorified.

Furthermore, running a public company is far more challenging than a private one, and management could have a lot of unforeseen hurdles to overcome.

These risk factors are what additional risk to the equation. And suppose a stock is not well received. In that case, IPO investors can end up with a disastrous position that they can’t dispose of until after the Lock-Up Period has expired. The 2019 WeWork disaster is a perfect example of this, and the Robinhood fiasco is another.

Having said that, when an IPO does succeed, it can generate substantial wealth in both the short and long term. The potential for explosive performance is what makes IPO investing so popular despite the higher level of risk.

Should I invest in an IPO?

Finding information about an upcoming IPO is relatively straightforward. Most exchanges like the New York Stock Exchange or Nasdaq will have all the details posted on their websites. And there are specialist services that help individual investors tap into these opportunities.

The decision to be an early investor through an Initial Public Offering is ultimately a personal one. The increased volatility surrounding these deals generally makes them unsuitable for low-risk tolerance investors.

Personally, I like to wait and see how a company performs over its first few quarters of being a publically traded stock. This usually provides a much more detailed picture of the business in general and helps eliminate the risk of accidentally jumping aboard the hype train heading for a giant chasm.

Saima Naveed does not own shares in any of the companies mentioned. The Money Cog has published a Premium Report on Robinhood Markets. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.