An Initial Public Offering (IPO) is the first time a company issues its share to the general public for investing in it. This is when a ‘private company’ officially becomes a ‘publicly traded company’.
In 2020, India witnessed as many as 15 IPOs that collectively raised an insane ₹26,611 crores. Moreover, 2021 is expected to be a blockbuster year for IPO enthusiasts for India, with the upcoming IPO of Life Insurance Corporation (LIC) expected to be the biggest in India ever.
Without getting into the details of how an IPO works behind the scenes, let’s discuss if it is profitable for the ordinary investor to put his money in an IPO.
Reasons to invest in an IPO
The main advantage of buying the shares before an IPO (also known as pre-IPO) is that you can potentially buy the shares at an earlier stage and at a cheaper valuation, compared to a normal investor at IPO or much after the IPO.
Because of this, you also get the opportunity to keep the shares for a longer time frame, i.e. even before they are publicly available for trading in the market. This can help generate more wealth than investing after an IPO. As the famous saying goes,“time in the market is more important than timing the market."
Another understated advantage is the ‘listing gains’ that a pre-IPO can provide. When a company gets listed on the stock market, it may be traded at a price that is either higher or lower than the allotment price. When the opening price is higher than this allotted price, it is known as listing gains.
However, many hedge funds and value investors (including legendary investor Warren Buffett) have publicly disclosed their aversion to the IPO frenzy and have advised innocent retail investors to stay away from it too. Let’s find out why they have to say that.
Reasons to NOT invest in an IPO
Despite the lucrative possibilities of a pre-IPO investment, it’s a very high-risk move and not one that investors should prefer spending their money in.
The first reason is the illiquid pre-IPO market. Since it’s a niche segment that trades over the counter and not through a recognized exchange, the liquidity could be very low, not giving you an opportunity to get rid of the shares if you feel like doing so or if you want to gain liquidity for any particular personal reason.
The second reason is the IPO timeline. The IPO of an unlisted company can get delayed due to market conditions or changes in plans within the company management. By this time, the fundamentals of a company could change drastically.
The third and most important reason is that before a company becomes public, there is no way to properly identify investor sentiment of the company, as opposed to already public companies. Ultimately, the share prices of companies are driven by investor sentiment, and the best indicator of investor sentiment is the movement of the share price itself, which one cannot know before the IPO.
While a pre-IPO subscription could be the gateway to building massive wealth, it is recommended by many investors to wait for the IPO and invest after market sentiment is understood and the fundamentals of these companies remain strong.
Even some of the highly rated companies have had terrible IPOs.
Just ask Snapchat.