Profit Minded

5 Myths about IPOs: The dangerous narrative of “the next big thing”

With the recent Twitter public offering, we may see "Mom and Pop," or retail, investors racing to invest in the "next hot IPO." Unfortunately, many of these investors will come out on the losing end of the equation.

Granted, some IPO deals are good for retail investors, but I'd argue the odds of that happening are stacked against you. Regulatory rules, designed to protect IPO investors, generate reams of disclosures about the company and the offering process, but unfortunately, many investors neither read nor understand these.

On an individual level, of course, there are strong companies that go public and yield high returns for initial investors. However, what I'm concerned by is a certain "narrative" about IPOs that relies heavily on several perceptions that are highly problematic.

Myth #1: Investing in an IPO gets you in on the ground floor.

People assume an IPO is an opportunity to "get in on the ground floor" of owning a good company. In reality, you're coming in on something like the fifth floor. By the time you buy shares of a company on Wall Street, other parties have almost always invested earlier at lower prices -- often, much lower prices.

Before you even knew about the company, there probably were three or four rounds of private investment, and the per-share price of ownership usually goes up with each round. Understandably, parties to each of those rounds expect a return for the risk they've taken, and that return often is realized following the IPO - when the investors are able to sell their ownership stakes for a profit. In fact, one of the big incentives for an IPO is so that previous investors - founders, venture capital firms, individual investors - can "cash out" at least a portion of what they've invested. This makes sense, as earlier investors get bigger returns for bigger risks. Face it: You could be late to the party. In the case of some weak companies that should not even be going public, you are in reality investing in a legal Ponzi scheme where a year later the price per share will be much lower than the offering price once the market moves towards rationality, which is usually the case.

Myth #2: If everyone's excited about the IPO, it must be a good investment.

At each stage of a company's life, new players enter the mix, and they might benefit even if the stock falls from its IPO price. Too many people assume that if the investment banks and analysts and earlier investors like the company, it must be a good investment now. That may or may not be true.

A public company is born after an entrepreneur grows the business and along the way, gets capital to grow via bank loans, investments by family members or private investors such as venture capital firms or private equity firms. Each time the company raises new money, new investors are willing to pay more for the stakes, so long as the company is performing well.

When a company decides to offer shares to anyone through a public offering, it will receive most of the proceeds from the sale. But existing shareholders gain a more liquid market to sell, and even if the stock price drops from the IPO, these investors will likely receive more than they paid.

In addition, the underwriter hired to buy the shares and re-sell them to other investors will get paid whether the stock soars or tanks when it opens on the exchange (called the secondary market).

Underwriters' fees typically range from 5 to 7 percent of the gross IPO proceeds. Underwriters are going to sell IPO shares to their favored customers, usually big mutual funds or pension funds. There is much pressure on pricing an IPO high, therefore, since commissions are a function of the price of the stock.

It's typically very difficult for the average individual investor to get in at this stage of a good IPO. As a result, when trading begins on the exchange, the only way most regular retail investors can buy shares is to be a big client of the underwriter or to pay a premium to any investors that sell immediately.

Myth #3: IPOs outperform their peers.

A key part of the IPO narrative is that they offer something, new, fresh, and somehow better than what is out there. The facts unfortunately say otherwise. Recent data from the University of Florida shows that IPOs from 1970-2011 underperformed other firms of the same size by an average of 3 percent in the five years after issuing. Between 2000 and 2011, the underperformance gap in 5-year returns narrowed to 1.8 percent, but it was biggest right after the IPO; in years one and two, IPOs underperformed by 18 percent and 6.3 percent, respectively.

Myth #4: If a company is going public, it must be strong financially.

The floor of the New York Stock Exchange is littered with companies that went public when they shouldn't have. Companies go public for a variety of reasons. Financial strength is, unfortunately, not always one of these reasons.

Vonage (VG) was posting losses equal to 72 percent of sales and was using $189 million in cash for operations in the year before its 2006 IPO. (Shares, which had an IPO price of $17 traded recently at $3.49.)

Plenty of warnings signs for Pets.com didn't stop its 2000 IPO at $11 a share. The pet-supply retailer had only three quarters' worth of historical financial data to show potential investors, and even that was bad: A loss of $61.8 million and $65.3 million in cash used for operations. The company folded by the end of the year.

Some more recent IPOs also had no business going through. Groupon (GRPN) has improved revenue since its 2011 IPO, but it's still not profitable, its cash flow has slowed and margins are narrowing. Shares are slightly more than half the IPO price. And FriendFinder Networks (FFNT.OB) had lost money for several years in a row and had negative net worth before it raised $50 million in a 2011 IPO priced at $10 (the company just recently filed for Chapter 11 bankruptcy).

Myth #5: All IPOs are high risk, high reward.

It's important to remember that not every IPO is bad. The danger lies in the assumption simply that IPOs are inherently good investment opportunities. Some are riskier than others and some have more potential for higher rewards than others. Fairly straightforward evaluation methods can be applied to companies filing for a public offering. When you filter companies through this evaluation, you can clearly discern that many of these companies are lousy performers. On the flip side, some companies like Microsoft (MSFT) are objectively good from a financial perspective, and they would have been great IPOs to get in on both because of their financial performance and their valuation at the time of IPO, which was reasonable.

How the IPO is priced matters. If the company is valued the right way, if it's profitable and growing, then maybe the first-day price on the exchange is a good one. Certainly, investors who bought shares of Chipotle Mexican Grill (CMG) at the 2006 IPO price of $22 have been rewarded (shares now trade around $440). Before its IPO, Chipotle was posting 7 percent margins and generating about $39.7 million in cash from operations.

Twitter might be a fantastic investment opportunity, and it might not; the truth is that we won't know until they share their S-1 filing with the public. As long as Twitter's filing and financial statements remain "confidential," an accurate analysis of their value is impossible. Hype and excitement doesn't necessarily equate to a good investment opportunity. If stocks continue to climb this year and the IPO line lengthens, I'm afraid you'll have plenty of opportunities to see if I'm right.

Mary Ellen Biery, Research Specialist at Sageworks, contributed to this article

Brian Hamilton is the chairman and co-founder of Sageworks . He is the original architect of the company’s artificial intelligence technology, FIND, the leading financial analysis technology for analyzing private companies. Hamilton’s area of expertise is the financial performance of privately held U.S. companies. He identifies high impact, macro trends with the Sageworks private company database and provides insight on the health of private companies for print, radio, and TV media outlets.

Brian has no positions in any stocks mentioned.

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