The ABCs of IPOs

The term "IPO" is bandied about as frequently as "the Dow," "DRIPs" and "P/E," but it's probably the most misunderstood of them all. I imagine some investors don't even know what the letters stand for. I once saw a cute T-shirt in a shop window showing the letters "IPO" followed by an arrow pointing downward. It was a shirt meant to be worn by a pregnant woman about to have her first child -- her "initial public offering" as it were.

If you're thoroughly confused about IPOs, don't worry. It will all become clear here, as we spell out the ABCs of IPOs. We will explain initial public offerings and why they may not be all they're cracked up to be.

What is an IPO?

An initial public offering (IPO) is basically a company's first sale of stock to the public. Typically, an IPO involves the stock from a young and oftentimes little-known, if not obscure, company. But occasionally, well-known and well-established firms do "go public." For example, last November, Rupert Murdoch's Australia-based media company News Corp. (NYSE: NWS) sold 18.6% of Fox Entertainment (NYSE: FOX) -- which owns, among other things, the FOX broadcast network, one of the top movie studios, and local TV stations -- to the public, raising $2.81 billion. Another well-known company planning to go public soon is none other than investment banking firm Goldman Sachs.

Now don't confuse a follow-on offering or a secondary offering with an IPO. A follow-on offering occurs when a company that's already public -- meaning it has already done an IPO -- sells more shares to the public. Think of the pregnant woman analogy. A woman can't have a firstborn more than once, but she can give birth multiple times. A secondary offering, on the other hand, involves selling shares belonging to existing shareholders.

Why do companies go public?

To raise money. Recently, it seems that just about every company with a "dot-com" in its name has been "cashing in" on investors' seemingly insatiable appetite for Internet company IPOs. The most extreme case of Internet mania of late involved online community theglobe.com (Nasdaq: TGLO), which shot up nearly 11 times its IPO price of $9 in its first day of trading, finishing the day up $54 1/2, or 600%, to $63 1/2. Not bad for a business run by two 24-year-olds who started out with $15,000 raised from family and friends. Immediately following the IPO, the stock traded mostly in the $30 to $45 range.

If you're a cynic, you might say that a company opts to go public because it expects to reap little profit -- making it cheaper to have shareholders than to owe fixed interest payments -- or that the company simply can't get funding from traditional lenders, meaning that it's in a high-risk business. If either is the case, as is true for many IPOs, you should avoid jumping on the IPO bandwagon at all costs.

Of course, there are legitimate reasons for going public, such as increasing the company's financial base, liquidity, prestige, and ability to attract management and make acquisitions. Or, it could be that an established company is spinning off subsidiaries to "unlock hidden value," as in the case of Fox Entertainment -- News Corp. has long complained that its shares have been undervalued.

Why don't companies go public?

Some companies choose to stay private so they don't have to share the profits, be accountable to shareholders, relinquish control over how the company is run, or disclose "secret" company information.

British "adventure capitalist" Richard Branson of Virgin Group makes a compelling argument against going public. In his recent autobiography, Losing My Virginity, Branson says that soon after the company's IPO he felt constrained by the "onerous obligations" of being a public company, especially the duty of appointing and working with outside directors. "Our business was not one that could be boxed into a rigid timetable of meetings. We had to make decisions quickly, off-the-cuff: if we had to wait four weeks for the next board meeting before authorizing Simon to sign UB40, then we would probably lose them altogether."

Branson also didn't want to follow the British tradition of paying a large dividend. He preferred the practice accepted in the U.S. and Japan of reinvesting profits to increase shareholder value. Branson views the one year Virgin was public as the company's least creative year because he and other top executives spent at least half their time talking to fund managers, financial advisers, and PR firms, explaining their business. The company's management ended up conducting a management buyout to make Virgin private again.

How to Get In on an IPO

You know the expression "I'll give my first-born?" Well, that's not too far a stretch from what it takes to get a piece of a "hot" IPO.

One of the most common questions asked in email to the Fool is, "How do I get in on an IPO?" As an individual investor without tens of millions of dollars to invest, you can see why, in the minds of stock brokers, you're pretty low on the totem pole. After researching the company and putting together a prospectus, the investment bankers underwriting an IPO take their clients on a "road show" (also known as a "dog and pony show") to attract buyers. The reason you've never been invited is because you're simply not the target audience. Investment bankers spend their time wooing analysts and large institutional investors, not individual investors.

Here's the catch: If the bankers think a stock will soar, they earmark much of the shares for their favorite institutional clients (ones that bring in the most in commissions). In a sense, brokerages use lucrative IPOs to curry favor with big clients, to win and retain their business. When brokers aren't so confident about the company's prospects, they will try to sell the stock to less-favored institutional clients. Clearly, the rich get richer, while the average investor gets left out.

Keep in mind that the underwriters' main customer in an IPO is the company going public. Don't think that they're doing you any favors selling you shares. If you're able to get your hands on some shares, it probably means that nobody else wants them, and you shouldn't either. Of course, there are exceptions, so do your own homework before passing up what might be a good buying opportunity.

If you're determined to try to get a piece of an IPO, you basically need to have an account with one of the underwriters. This could conveniently mean your existing broker, or it could mean you'll have to set up a new account with another broker. Check with your existing broker first, and then check the offering prospectus for a full list of underwriters. Of course, there's no guarantee that you'll actually get in on the IPO or get your hands on as many shares as you want.

Hazards of 'flipping' IPOs

If you want to get in on an IPO so that you can "flip" the stock -- that is, resell it for a quick profit -- while it's hot, be forewarned: it's not as easy as it sounds. First of all, chances are your broker will "strongly encourage" that you hold on to the stock for at least a month or two. While there's no rule prohibiting you from flipping the stock, you'll probably be blacklisted for future offerings if you do. So if you cash in on your profit now, you risk being shut out of future IPOs.

The reason brokers, including online brokerages, discourage clients from flipping IPOs is that they themselves don't want to be shut out of future offerings or lose commissions because too many of their customers flip stocks. The companies going public prefer to have long-term shareholders, not a bunch of day-traders looking to "earn" a quick buck.

Lest you get the wrong impression, the rule just described does NOT apply to institutional investors, who routinely flip stocks at will without being "punished." While it's terribly unfair that institutional investors operate under different rules from individual investors, you won't get much sympathy from these quarters on the issue of flipping. After all, Fools believe in investing for the long term, and flipping IPOs is downright unFoolish.

Why you should avoid IPOs

Aside from the pitfalls already mentioned above, the whole process of taking a company public -- distributing a prospectus, going on a road show, doing interviews with the media, etc. -- is one big hype job for the company in question. Sometimes it's the most attention a company will ever get.

It's easy for investors to get swept up in the hype, to perceive the IPO as some sort of once-in-a-lifetime opportunity, to forget that the company will be publicly traded and its shares readily available on the open market. Keith Pelczarski (TMF Czar), who spent his pre-Fool days working with IPOs at a major brokerage firm, once said, "Investors are drawn to these hot issues like moths to a flame, and just like those moths, many get burned."

A good rule of thumb is: If you don't get in on an initial offering, don't be sucked in by the hype and buy shares of an IPO on its first day of trading. More often than not, you'll end up buying at an inflated and unsustainable price. If the stock is worth owning, it will most likely be worth owning weeks, months, or even years after the hype has died down.

Case in point: I was interested in the Fox Entertainment IPO last November. Knowing that the heavily touted issue would be hard to come by, I waited it out. Despite a slight initial run-up in the stock price, I was able to buy shares at the IPO price about a month after the company went public. In fact, after I made the purchase, the shares dropped further, falling as low as $3 below the IPO price of $22.50 a share. The moral of the story: Save yourself the headache. You can make money without ever participating in an IPO.

Generally speaking, most decent IPOs will experience a price run-up immediately after they start trading, only to come down to a more rational level once the buzz dies down. One study showed that investors who bought shares of an IPO at the closing price on its first day of trading saw a 2% annual return on the investment. In short, you'd be better off keeping the money in an interest-bearing savings account.

On average, IPOs make bad investments. A study by two university professors a few years back looked at 4,753 IPOs and 3,702 secondary offerings made between 1970 and 1990. In the six months following the offering, IPO firms lost 1.1%, versus a 3.4% gain for matching firms that made secondary offerings. The new issues continued to underperform over the next three years, with the gap narrowing but persisting well into the seventh year following the IPO. During the 20 years covered by the study, the average annual return over the five-year period following the offering was 5.1% for the new issues and 11.8% for the comparable firms.

Not surprisingly, companies make offerings when the market is up, when business is going well -- essentially, when they can sell shares at the highest price possible. In other words, don't expect a bargain in an IPO. More likely than not, you'll be getting shares that are closer to being overvalued than undervalued.

Unconventional IPOs

To further entice eager beaver investors, new forms of IPOs have popped up on the scene. There are the Travelzoo.com-type of IPOs, which are essentially marketing campaigns designed to draw traffic to a website (in this case, a travel-related website) by giving away free shares. According to Travelzoo.com, 700,000 people registered to be shareholders within three months. The company says it reported its first profitable quarter in the period ended September 30, 1998.

A website called exit23b gave away shares before it even had a website. Unlike the Travelzoo.com offer, where every registrant picked up a few shares, at exit23b you entered a drawing in which "10 lucky winners" got 10,000 shares each -- sounds a lot like a lottery. As of this writing, the site is still under construction, and visitors to the site are told, "We hope exit23b will be your favorite place to buy electronics, interactive gaming, music & video. In short, all things entertainment." The site launch is now slated for April -- the builders had said the site would launch in early March back in February when people were still entering the drawing.

A more legitimate new source of IPOs can be found at OpenIPO.com, the brainchild of Hambrecht & Quist (NYSE: HQ) founder and former chairman Bill Hambrecht. His new investment banking firm, W.R. Hambrecht + Co., is taking companies public by auctioning shares over the Internet. The firm's first IPO comprises 1 million shares -- a 22% stake -- in Ravenswood Winery, a highly regarded premium winemaker based in Sonoma, California, which will trade on Nasdaq under the symbol "RVWD." The "Dutch auction" opened February 8 and will close no earlier than March 22.

Since all bids are sealed in a Dutch auction, the idea is that the final IPO price should reflect what investors are truly willing to pay for the stock. The way this works is that investors participate by making a bid for what they believe the company is worth, whether it's within, above, or below the estimated pricing range -- $10.50 to $13.50 for Ravenswood. Bids can be changed or withdrawn up until the close of the auction, at which time W.R. Hambrecht will set a single offering price -- based on the bids received -- at which all shares can be sold. That means some investors may end up paying less than their bids. Those bidding below the set offering price won't get to buy any shares.

Another recently founded online investment bank is called E*OFFERING, whose website is still under construction. The bank was started by online brokerage firm E*TRADE Group (Nasdaq: EGRP); Sandy Robertson, founder and former CEO of Robertson, Stephens & Co.; and Walter Cruttenden III, former CEO and president of Cruttenden Roth. The new company plans to give E*TRADE customers greater access to public offerings and reduce underwriting fees for companies going public. E*OFFERING plans to begin underwriting offerings later this year.

The pioneer among online IPO specialists is Wit Capital, which in the past year and a half has participated in more than 50 offerings, including the IPOs of Prodigy Communications (Nasdaq: PRGY), MarketWatch.com (Nasdaq: MKTW), TicketMaster Online-CitySearch (Nasdaq: TMCS), and Ziff-Davis (NYSE: ZD). Unlike OpenIPO.com and E*OFFERING, Wit Capital doesn't act as the lead underwriter.

While it's good news for individual investors that there are now an increasing number of opportunities to get in on IPOs, keep in mind that IPOs are still highly risky investments, especially if you don't do your own research. In fact, if you view IPOs as some sort of get-rich-quick scheme, you're really better off refraining from investing in them altogether. Whatever you do, proceed with caution.

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