Speak the Basics
By Darren Chervitz, CBS MarketWatch
In the sometimes mundane world of investing, initial public offerings are shrouded in mystique.
The world of newly public companies, after all, remains off limits for most individual investors, although that is slowly beginning to change.
Apart from the sex appeal and the potential for big returns, however, investing in IPOs is risky business. One simple fact anybody interested in jumping in the new issue market should know: Year in and year out, IPOs have historically underperformed the broader market.
Obviously, investors need to get beyond the allure and hype of IPOs and become educated about the facts.
Following are some definitions of terms commonly used in the IPO market.
American Depositary Receipts (ADRs) — These are offered by non-US companies wishing to list on a US exchange. They are called "receipts" because they represent a certain number of a company's regular shares.
Aftermarket performance — Used to describe how the stock of a newly public company has performed with the offering price as the typical benchmark.
All or none — An offering which can be canceled by the lead underwriter if it is not completely subscribed. Most best-effort deals are all or none.
Best effort — A deal in which underwriters only agree to do their best to sell shares to the public, as opposed to much more common bought, or firm commitment, deals.
Book — A list of all buy and sell orders put together by the lead underwriter.
Bought deal — An offering in which the lead underwriter buys all the shares from a company and becomes financially responsible for selling them. Also called firm commitment.
Break issue — Term used to describe a newly issued stock that falls below its offering price.
Completion — An IPO is not a done deal until it has been completed and all trades have been declared official. Usually happens about five days after a stock starts trading. Until completion, an IPO can be canceled with all money returned to investors.
Direct Public Offering (DPO) — An offering in which a company sells its shares directly to the public without the help of underwriters. Can be done over the Internet. Liquidity, or the ability to sell shares, in a DPO is usually extremely limited.
Flipping — Buying an IPO at the offering price and then selling the stock soon after it starts trading on the open market. Greatly discouraged by underwriters, especially if done by individual investors.
Greenshoe — Part of the underwriting agreement which allows the underwriters to buy more shares — typically 15% — of an IPO. Usually done if a deal is extremely popular or was overbooked by the underwriters. Also called the overallotment option.
Gross spread — The difference between an IPO's offering price and the price the members of the syndicate pay for the shares. Usually represents a discount of 7% to 8%, about half of which goes to the broker who sells the shares. Also called the underwriting discount.
Indications of interest — Gathered by a lead underwriter from its investor clients before an IPO is priced to gauge demand for the deal. Used to determine offering price.
Initial public offering (IPO) — The first time a company sells stock to the public. An IPO is a type of a primary offering, which occurs whenever a company sells new stock, and differs from a secondary offering, which is the public sale of previously issued securities, usually held by insiders. Some people say IPO stands for "Immediate Profit Opportunities." More cynicIt's Probably Overpriced."
Lead underwriter — The investment bank in charge of setting the offering price of an IPO and allocating shares to other members of the syndicate. Also called lead manager.
Lock-up period — The time period after an IPO when insiders at the newly public company are restricted by the lead underwriter from selling their shares. Usually lasts 180 days.
New issue — Same as an IPO.
Offering price — The price that investors must pay for allocated shares in an IPO. Not the same as the opening price, which is the first trade price of a new stock.
Opening price — The price at which a new stock starts trading. Also called the first trade price. Underwriters hope that the opening price is above the offering price, giving investors in the IPO a premium.
Oversubscribed — Defines a deal in which investors apply for more shares than are available. Usually a sign that an IPO is a hot deal and will open at a substantial premium.
Penalty bid — A fee charged to brokers by the lead underwriter for having to take back shares already sold. Meant to discourage flipping.
Pipeline — A term used to describe the stage in the IPO process at which companies have registered with the SEC and are waiting to go public.
Premium — The difference between the offering price and opening price. Also called an IPO's pop.
Prospectus — The document, included in a company's S-1 registration statement, which explains all aspects of a company's business, including financial results, growth strategy, and risk factors. The preliminary prospectus is also called a red herring because of the red ink used on the front page, which indicates that some information � such as the price and share amounts � is subject to change.
Proxy — An authorization, in writing, by a shareholder for another person to represent him/her at a shareholders' meeting and exercise voting rights.
Quiet period — The time period in which companies in registration are forbidden by the Securities and Exchange Commission to say anything not included in their prospectus, which could be interpreted as hyping an offering. Starts the day a company files an S-1 registration statement and lasts until 25 days after a stock starts trading. The intent and effect of a quiet period have been hotly debated.
Road show — A tour taken by a company preparing for an IPO in order to attract interest in the deal. Attended by institutional investors, analysts, and money managers by invitation only. Members of the media are forbidden.
Selling stockholders — Investors in a company who sell part or all of their stake as part of that company's IPO. Usually considered a bad sign if a large portion of shares offered in an IPO comes from selling stockholders.
S-1 — Document filed with the Securities and Exchange Commission announcing a company's intent to go public. Includes the prospectus; also called the registration statement.
Spinning — The practice by investment banks of distributing shares to certain clients, such as venture capitalists and executives, in hopes of getting their business in the future. Outlawed at many banks.
Syndicate — A group of investment banks that buy shares in an IPO to sell to the public. Headed by the lead manager and disbanded as soon as the IPO is completed.
Venture capital — Funding acquired during the pre-IPO process of raising money for companies. Done only by accredited investors.
Know the Process
A company that is thinking about going public should start acting like a public company as much as two years in advance of the desired IPO. Several steps experts recommend include preparing detailed financial results on a regular basis and developing a business plan.
Once a company decides to go public, it needs to pick its IPO team, consisting of the lead investment bank, an accountant, and a law firm.
The IPO process officially begins with what is typically called an "all-hands" meeting. At this meeting, which usually takes place six to eight weeks before a company officially registers with the Securities and Exchange Commission, all the members of the IPO team plan a timetable for going public and assign certain duties to each member.
Selling the deal
The most important and time-consuming task facing the IPO team is the development of the prospectus, a business document that basically serves as a brochure for the company. Since the SEC imposes a "quiet period" on companies once they file for an IPO -- which generally lasts until 25 days after a stock starts trading -- the prospectus will have to do most of the talking and selling for the management team.
The prospectus includes all financial data for a company for the past five years, information on the management team, and a description of a company's target market, competitors, and growth strategy. There is a lot of other important information in the prospectus, and the underwriting team goes to great lengths to make sure it's all accurate. We take a closer look at the prospectus in part three of this series.
Once the preliminary prospectus is printed and filed with the SEC, the company has to wait as the SEC, the National Association of Securities Dealers (NASD), and other relevant state securities organizations review the document for any omissions or problems. If the agencies find any problems with the prospectus, the company and the underwriting team will have to make fixes with amended filings.
In the meantime, the lead underwriter must assemble a syndicate of other investment banks that will help sell the deal. Each bank in the syndicate will get a certain number of shares in the IPO to sell to clients. The syndicate then gathers indications of interest from clients to see what kind of initial demand there is for the deal. Syndicates usually include investment banks that have complementary client bases, such as those based in certain regions of the country.
On the road
The next step in the IPO process is the grueling whirlwind multicity world tour, also known as the road show. The road show usually lasts a week or two, with company management going to a new city every day to meet with prospective investors and show off their business plan.
The typical US stops on the road show include New York, San Francisco, Boston, Chicago, and Los Angeles. If appropriate, international destinations like London or Hong Kong may also be included.
How a company's management team performs on the road show is perhaps the most crucial factor determining the success of the IPO. Companies need to impress institutional investors so that at least a few of them are willing to purchase a significant stake.
The road show is also the most blatant example of how unfair the IPO market can be for the average investor. Only institutional and big-money investors are invited to attend the road show meetings, where statements regarding a company's business prospects -- discussed only minimally in a prospectus -- are talked about quite openly. According to the SEC, such disclosures are legal, as long as done orally.
The SEC hasd new rules that, ifapproved, will make it easier for companies to broadcast their road showsover the Internet.
Once the road show ends and the final prospectus is printed and distributed to investors, company management meets with their investment bank to choose the final offering price and size.
Investment banks try to suggest an appropriate price based on expected demand for the deal and other market conditions. The pricing of an IPO is a delicate balancing act. Investment firms have to worry about two different sets of clients -- the company going public, which wants to raise as much money as possible, and the investors buying the shares, who expect to see some immediate appreciation in their investment.
Investment banks usually try to price a deal so that the opening premium is about 15%. Of course, many hot Internet IPOs have risen much more than that on their first day.
If interest in an IPO appears to be flagging, it's common for the number of shares in the offering or their price to be cut from the expected ranges included in a company's earlier registration statements. If a deal is especially hot, the offering price or size can also be raised from initial expectations. Although it is rare, a company can postpone an offering because of insufficient demand.
Let the games begin
Once the offering price has been agreed on -- and at least two days after potential investors receive the final prospectus -- an IPO is declared effective. This is usually done after a market closes, with trading in the new stock starting the next day as the lead underwriter works to firm up its book of buy orders.
The lead underwriter is primarily responsible for ensuring smooth trading in a company's stock during those first few crucial days. The underwriter is legally allowed to support the price of a newly issued stock by buying shares in the market or selling them short (which means selling shares it doesn't have in its account). It can also impose penalty bids on brokers to discourage flipping, which is selling shares in an IPO soon after the stock starts trading. This ability to control the price of an IPO somewhat is one reason investors feel it's such a negative when a stock quickly falls below its offering price.
An IPO is not declared final until about seven days after the company's market debut. On rare occasions, an IPO can be canceled even after a stock starts trading. In such cases, all trading is negated and any money collected from investors is returned.
A look at the prospectus
Adequate research is, without a doubt, the most effective way to identify and stay away from the IPO disasters waiting to happen. The prospectus, which contains nearly all aspects of a company's business and game plan, is the first place any investor interested in purchasing a new issue should look.
Finding an online prospectus is a snap
Getting a prospectus is easy. If you're reading this online, you should be able to electronically download a prospectus without any problem. Prospectuses for all US companies are available for free from the Securities and Exchange Commission's Web site, FreeEDGAR.com, or on a delayed basis from EDGAR Online.
If you don't have access to a computer -- or your access is too slow for downloading a prospectus (which is an extremely long document) -- you can also obtain a prospectus by calling the investment banks that are involved in selling the shares of an IPO. Calling the company will also work.
The fine print: A confusing read
Warning: A prospectus is not an easy read. Written mostly by lawyers, they are laden with confusing jargon.
In addition, the tone of these documents is decidedly negative. Companies have to be completely honest about all of their warts in order to avoid future lawsuits. Thus, bullish statements are often followed by cautionary disclaimers, and there's an entire section titled "Risk Factors" dedicated to what may go wrong at the company.
Before you get scared off from investing in an IPO, however, you should realize that many of these risk factors and disclaimers are included in every prospectus. Then again, just because they're boilerplate doesn't mean you shouldn't pay attention.
Following is a list of some warning signs that prospective IPO investors should pay close attention to. In general, they're listed in order of where one would find them in the prospectus, from the front of the document to the end.
Again, this is only a partial list, and in the final analysis, what's most important is that an investor feels comfortable with a company, its business, its market position, its growth strategy, and its management.
Second-tier investment banks -- Investment banks hired by a company to handle an IPO must do a fair amount of due diligence, so it's always comforting when the names on the front of a prospectus are well-known and well-regarded. Of course, even the best banks take out some turkeys. Plus, a number of small regional banks have solid reputations. Just be a little more careful if the name of the investment bank doesn't ring a bell. Found on bottom of front page.
Recent developments -- This section, usually added to amended filings, updates any recent notable events, often how a company performed in its most recent quarter. Make sure this section is mainly good news. Usually found in "Recent Developments" (not always there).
Selling stockholders -- It's usually a bad sign when a large number of shares in an IPO come from selling stockholders, meaning pre-offering investors who are cashing out. Not only does it mean that the company won't receive the money from the sale of those shares, but it also should make one wonder why investors would want to sell their shares so quickly if a company's prospects are strong. In fact, investors usually prefer that management retain a sizable stake in the firm after the offering is completed. The number of selling stockholders is found in a section called "The Offering," while management's total stake can be found in "Principal and Selling Stockholders."
Use of proceeds -- If a company is st majority of the money to pay off debt or dole out a huge dividend to pre-IPO investors, watch out. That means people buying shares in the IPO are in essence paying for the company's past, not its future. Also be careful when a company says it's allocating most of the money for general corporate purposes. It's comforting if a company has more specific ideas about where your money will be invested -- acquisitions, advertising, capital formation, research and development, etc. Found in "Use of Proceeds."
Declining revenue -- If revenue for a company's most recent fiscal year is down from the year-ago period, it may be time to run as far away as possible. Revenue for companies looking to go public should be growing rather significantly. Even slowing revenue growth is a warning sign. At the very least, read a company's explanation for the revenue slowdown, found later in the prospectus. Revenue totals can be found in "Summary Consolidated Financial Data" or "Selected Consolidated Financial Data." The explanation behind the results is found in "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Declining margins -- Along the same lines as declining revenue, declining operating margins are not a good sign. It means the company is becoming less and less profitable. However, if a company is in a fast-changing, highly competitive industry, it may need to sacrifice profitability for market share and brand equity. Again, read the explanation behind the shrinking margins. Margin totals found in "Summary Consolidated Financial Data" or "Selected Consolidated Financial Data." Explanation behind results can be found in "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Working capital deficit -- This is when a company's liabilities, or debts, are greater than its assets. This is not uncommon for a new issue, but it should be explained and should disappear on an "as adjusted" basis after the completion of the offering. Details can be found in "Summary Consolidated Financial Data" and an explanation is in "Liquidity and Capital Resources."
Other financial red flags -- A number of other problems can be found on a company's balance sheet or income statement. Things such as inventories or accounts receivable rising more rapidly than revenue, high interest expenses, or extraordinary charges should be explained. Found in "Selected Consolidated Financial Data" with more detail in the "Index to Consolidated Financial Statements."
Over-reliance on one customer -- A clear danger sign. Several IPOs have imploded after the companies announced they were losing one of their major customers. Of course, like all of these warning signs, there are exceptions. Found in "Risk Factors."
Supplier reliance -- A company can be too reliant on its suppliers as well as its customers. Make sure a firm can switch from one supplier to another rather easily. Suppliers that double as competitors are another danger. Found in "Risk Factors."
Competition -- Given that monopolies are illegal, competition will always be there, but you better watch out if some well-run, well-capitalized firms are on the list. One name that jumps quickly to mind: Microsoft. Found in "Risk Factors" and "Business."
Other risk factors -- Patent disputes, heavy indebtedness, and litigation are just some of the other more dangerous risks. Read the entire "Risk Factor" section carefully, but don't get overly discouraged.
Too-small pie -- No matter how effective a company is at selling widgets, there needs to be enough people willing to buy those widgets at high-enough prices. A company's target market should be large and rapidly growing. This information can be found in the "Business" section.
Decliningvaluation -- Pre-offerint an IPO be priced so they get a huge return on their initial investment, often as much as 10 times. You can find out what those original investors paid on average for their shares in the section entitled "Dilution." Compare that to the offering price. If the two prices are close, then you can bet pre-IPO investors at one point were too optimistic about the valuation for the company. While it may seem like a good deal to buy a company for about the same price as earlier investors, there's a reason for the lower valuation. On very rare occasions, IPO investors can actually pay less on average than the company's pre-offering backers.
Overvaluation -- A lot of factors go into determining an IPO's offering price and not all of them have to do with the price-to-sales or price-to-cash flow multiples that determine the value of most other stocks. Unfortunately, professional investors are at an advantage since they can often find out a company's sales and earnings projections. As a regular retail investor, you won't get any future estimates until analysts start covering the new issue about 25 days after the stock starts trading. Still, you can compare how companies are valued to past results. Just take the number of shares outstanding after the offering, multiply it by the expected offering price (take the midpoint of the listed pricing range), and find out what the market value of the company will be. Then, divide that figure by the firm's revenue and profit for the past four quarters. Hopefully, these multiples, although rough calculations, will be comparable to similar publicly traded companies. Number of shares outstanding is found in "The Offering," expected offering price range is usually found on the front page (but it is not always there), and quarterly sales results are usually found in "Selected Consolidated Financial Data" (if quarterly results are not available, use results from the most recent fiscal year).
Overcompensated or overmatched management -- You usually don't want members of the management team in a newly public firm to be making hundreds of thousands of dollars in base salary. Rewards are fine, but make sure most of them are in the form of stock options. That way, management will only be rewarded if the shareholders are. Also, look for a management team that has extensive experience in the industry and/or with other public companies. A chief financial officer with little experience running a public company could be overwhelmed by the duties. In addition, watch out for an executive team or board of directors filled with relatives. Nepotism rarely makes for solid management. Found in "Management" and "Executive Compensation."
"Going concern" statement -- If a company's accountant says that the firm's business results raise "substantial doubt about the firm's ability to continue as a going concern," watch out. It usually means that a company needs the IPO pretty badly to continue paying off its obligations. Many companies avoid getting plagued with this scarlet letter by raising money immediately prior to the IPO. Found in "Report of Independent Auditors."
Play the game
Many investors fret they'll miss the next big thing because they have no access to the IPO market, but study after study has proven that IPOs historically underperform the broader markets.
This fact should come as no surprise considering that new issues are high-risk, high-reward investments. Pick the right stock and you could score big, but the more likely scenario is that your hot IPO will be languishing below its offering price in a few years.
This series of IPO Basics includes a definitions of terms found on financial statements, covers the basic definitions needed to understand the IPO process, and looks at the prospectus. In this final report, we discuss investment strategy.
The ground floor
Obviously, one of the best ways to invest in an IPO is to buy shares at the offering price from one of the banks managing the deal, before the stock starts trading. New issues are usually reasonably priced by the lead underwriter, which typically hopes for a 15% premium above the offering price when the stock starts trading.
For your average retail investor, however, buying shares at the offering price before the stock starts trading is a difficult task. But it's a bit easier now that banks have made an effort to reach out to the retail investor community through alliances and mergers.
To buy an IPO at the offering price, you'll need to have an account with a broker that has access to that deal, meaning one of the banks that is part of the selling syndicate. These will be brokers that also have corporate finance divisions, such as Merrill Lynch, Wit Capital, or Salomon Smith Barney, or discount brokers that have signed a distribution alliance with a traditional investment bank, such as E-Trade or Schwab or DLJDirect. The names of the banks on the syndicate for any given deal can be found by looking at the "Underwriting" section in a company's SEC registration.
Tell your broker
Then, it's just a matter of letting your broker know how much you would like to invest in the IPO. Whether you're successful depends on many factors: how many shares are being offered in the deal (the more, the merrier), how large an allocation your broker's bank is getting (the lead underwriter will have the largest allotment), how large your account is, how much trading you do, how close your relationship is with your broker, how well your broker knows the business, how successful your broker is, etc.
Many brokers, especially the greener ones, don't even realize they could get IPO allocations for clients. Brokers get fat commissions for selling shares in new issues, so they're usually reserved for the best, most industrious salespeople.
If you want to invest in an IPO but don't have a relationship with one of the managing banks, you can also try to start an account, making it a condition that you receive some shares in the new issue you're interested in, but you may not have much luck with this tactic. IPO shares are saved to reward a firm's biggest, most active, and longest-standing customers.
With an electronic brokerage that's participating in an IPO, the allocation process is more objective, although no less difficult. Some firms, such as DLJDirect, only give shares to customers with a certain account size; others allocate shares based on statistics such as trading frequency to reward their best and most profitable customers.
Wit Capital uses a quasi first-come, first-served system, allocating shares via a random lottery to all investors who respond to their solicitation e-mails within a certain time frame.
Of course, even investors able to get shares in an IPO willnot be able to sell those shares right after the stock starts trading, a process called flipping that is often employed by institutional investors to boost returns. Try to flip, and you'll probably never get an allocation in an IPO again, at least not from the same broker.
Electronic brokers are particularly harsh against quick sellers. Wit Capital, for instance, says it puts those who sell their IPO shares in the first 60 days at the bottom of the priority list in upcoming deals, while E-Trade also punishes flippers by restricting allocations in the future.
Patience is a virtue
If you can't get in on an IPO at the offering price, what's the next best time to invest? Analysts have differing opinions on this, but most agree on one point: You must be patient.
It may be incredibly exciting to watch a stock like Netscape or theglobe.com soar on the first day of trading, but it's a potentially dangerous way to invest, especially if you're planning to be in for the long term.
When a stock first starts trading, its price will nearly always rise to an artificially high level. First of all, investor demand is often unusually heavy because of the hype surrounding an IPO and the strong selling effort employed by the syndicate
In addition, the lead underwriter is legally allowed to support the stock price of a newly public company, either by buying shares in the open market or by imposing harsh penalty bids on brokers who return shares in a new issue.
While this early momentum can last for several days or longer, it ALWAYS ends, at least temporarily. "Within three months or four months the stock price (of an IPO) will usually sag," said Kathy Smith, an analyst at the Greenwich, Connecticut-based Renaissance Capital, an IPO research firm that manages the IPO Fund. "A wait-and-see approach can really pay off."
For example, Amazon.com's stock gained a bunch on its first day of trading but it was actually trading at less than its offering price a week later. Amazon's a bit of an unusual case, but most new issues will show some significant price weakness within the first six months of trading.
The research report
Another benefit of waiting a bit before investing in a new issue is the analyst research report, which comes out about 25 days after a stock starts trading. Because the analysts who first start covering a new issue work at the banks that helped bring the company public, these "rah-rah" reports nearly always include a "buy" or "strong buy" rating and rarely make much of an impact on a stock price. However, they do provide some food for thought as well as revenue and earnings estimates which can help an investor decide on an appropriate valuation.
If you're determined to get in on an offering on the first day, always use limit orders, which allow you to set the maximum amount you're willing to spend. Limit orders may not always get filled, but you may get saddled with a wildly overvalued stock if you use a regular market order.
Struggling IPO market
Just like all markets, the world of IPOs goes through cycles. When it's in a downturn, as it was in the spring of 1996, deals that are lucky enough to get out are often priced at bargain-basement prices. That's when the smart investor is looking hardest to jump in.
Take, for instance, the March 1996 debut of Internet auctioneer Onsale, which could barely find any bidders at a lower-than-expected $6 offering price; the stock was below $5 within weeks. Later in the year, when the market turned around for Internet stocks, Onsale's price surged more than 500%.
A first-class jockey
Another strategy analysts recommend is buying on the strength of the underwriter. Year in and year out, deals from Goldman Sachs, Merrill Lynch, and Morgan Stanley Dean Witter perform near the top of the list.
Along the same lines, say analysts, stay away from the small underwriters or the tiny deals. Renaissance Capital's Smith defines a small underwriter as a bank that does not do its own research and only sells to individual investors. "Institutions may be deal hogs, but they demand research and provide credibility," she says.
A small deal is an IPO which places a company's market value (shares outstanding times offering price) at less than $50 million, Smith adds.
Funds and (gasp!) shorting
If you don't have the time to do adequate research for your own stock picking, you may want to consider putting money in a growth-oriented mutual fund that invests heavily in new issues. Renaissance Capital has started such a fund, and you can contact Morningstar for others out there that fit the bill.
Finally, an investor may want to consider shorting a new issue, which is when an investor sells borrowed stock in hopes of buying it back at a lower price and pocketing the difference.
Shorting a hot IPO is a dangerous strategy that Smith says requires a "stomach of steel," but if timed right (wait until all the initial momentum has faded), the opportunities are large. In order to short a stock, you'll have to find shares to borrow, which isn't easy in a new issue, and you'll need a margin account with your broker.