Ever since the Dutch East India Company became the first to issue stocks and bonds to the public in 1602, investors have seen initial public offerings (IPOs) as the road to riches.
The current hype surrounding the Facebook IPO is just one example.
But investors tempted by Facebook (Nasdaq: FB) may want to think back to the dotcom craze of the late 1990 s. You'll remember it spawned a feeding frenzy among investors chasing after internet IPOs on an almost daily basis.
It wasn't long before investors on Main Street took the bait after watching hordes of new college graduates in Silicon Valley become instant millionaires.
But as companies with unproven business models executed massive IPOs with sky-high prices, every day investors who succumbed to the siren call got clobbered.
Pets.com for instance, raised $82.5 million in an IPO in February 2000 before imploding nine months later. And EToys.com stock went from a high of $84 per share in 1999 to a low of just 9 cents per share in February 2001.
In both cases, small investors were left holding the bag. The point is IPOs have always been high-risk, high-reward.
So, what is an IPO anyway? How do people get rich-and go broke-- so fast? And, more importantly, should you invest in an IPO like Facebook for instance?
Here's what you need to know...
Investing in IPOs: Why Go Public?
Simply put, most companies go public to raise capital, either by issuing debt or stock.
First of all, being publicly traded opens the door to potentially huge returns for the owners.
But that's not all.
Public companies pay lower interest rates when issuing bonds. They also can issue more stock to grow through mergers and acquisitions.
Then there's the prestige factor, the pure ego satisfaction of hobnobbing with the fat cats on Wall Street.
But from an investor's point of view, the road to prosperity with companies going public is fraught with peril.
Even still, to most retail investors IPO s are exciting because you usually can't buy into a successful private company.
But let's not kid each other...
The odds of buying a piece of a hot IPO (known as an IPO allocation) are slim to none. Most IPO s leave retail investors completely behind.
You see, the only way to get in on an IPO is to have a relationship with one of the underwriters -- typically investment banks like Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM) or Morgan Stanley (NYSE: MS).
The underwriters work behind the scenes with the company to compile the proper regulatory filings with the Securities & Exchange Commission, handle the paperwork and determine the offering price of the stock.
If the underwriters know the IPO will be in great demand and the price is likely to jump, they'll shower their favorite institutional clients with an allocation at the initial price.
The big boys are then free to ride the initial surge on the first day of trading and dump the shares when the public jumps in. The whole idea is to line the pockets of big clients, leaving nothing on the table for the little guy.
Take Groupon Inc.'s (Nasdaq: GRPN) recent IPO, for example. Shares were initially priced at $20, but saw such heavy demand that the stock opened at $28. After a brief spike above $30 on its first trading day, the stock has fallen below $13.
Bottom line, only the biggest clients with the deepest pockets are going to get in on a hot IPO.
Facebook IPO: Ignore the Hype
You should be especially cautious if your broker calls you with an allocation for a hot IPO. It's probably because nobody else wants them.
It's important to remember that the underwriters are salesmen whose job it is to generate as much talk on "the Street" as possible. They often put on "road shows"-like Facebook did-- pitching IPOs as "once in a lifetime" opportunities.
But if you're thinking about investing in IPOs, the operative words should be "buyer beware."
In fact, if you look at the charts, you'll notice many IPO stocks tank after a few months.
That's because underwriters won't do an IPO without a contract signed by key employees prohibiting them from selling any shares of stock for a specified period of time - known as the "lock-up period."
The period can range anywhere from 3 to 24 months but 90 days is the minimum period stated under law.
Thing is, at the end of the lockup period, insiders usually sell their stock to bank their profits, driving the stock down.
But you can still make money on companies going public.
You just have to do your homework.
For instance, Amazon.com (Nasdaq: AMZN) went public on May 15, 1997, with an IPO valuation of $441 million. T oday it's $101 billion.
EBay Inc.'s (Nasdaq: EBAY) IPO valuation on Sept 24, 1998 was $2 billion. T oday it's $51 billion.
Just remember, don't buy a stock just because it's an IPO -- buy it because it's a great investment.
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