BULLS & BEARS: Healthy skepticism needed when considering an IPO

It is the goal of many wide-eyed entrepreneurs to take a company public. While private businesses are usually closely held by a small number of shareholders, an IPO enables a company to expand its shareholder base.

By listing its shares on a stock exchange, a company is exposed to a wide range of investors who are provided the opportunity to review its financial statements and buy and sell the company’s shares.

Initial public offerings serve as a key capital-raising mechanism in our marketbased economy. There are many reasons to take a company public. Public companies generally enjoy greater access to capital and lower borrowing costs to grow their business. A publicly traded stock can also serve as currency to make acquisitions of other businesses.

An IPO also provides liquidity to earlystage investors in the company. In most initial public offerings, a portion of the stock being offered is from selling stockholders. In this case, the IPO facilitates an exit strategy for venture capitalists and other private investors who took on the early risk providing the seed financing for the business and now want their return on the investment.

Of course, the late 1990s was the heyday and, ultimately, the disgrace of the IPO. Entire books will be written about this era of greed and shame in stock market history. There is plenty of blame to go around during this period, from the Wall Street firms that foisted overvalued shares on a novice but greedy public to the venture capitalists and managements that raced these nascent companies to market with nothing more than a business concept or, at best, well before they were sustainable operating businesses.

Many buyers-it would be a mistake to call them investors-of those “new era” IPOs scored huge profits in weeks or days by “flipping” shares. A number of mutual fund managers engaged in this flipping behavior while touting eye-popping returns to the investing public, leading to large money flows into their funds. Only when the game stopped and investors got stuck with wildly overpriced stocks did they see there was no talent behind the track records.

Some companies lavished with market valuations in the billions of dollars became worthless in short order. Most of the large investment banks were hit with stiff monetary penalties for their role in the fiasco and are today still mired in thorny litigation.

The lesson is that investing in IPOs, much like any other investment, requires a high level of due diligence. Investors should thoroughly study the offering prospectus, a document that outlines the prospects and risks along with historical financial statements.

Be wary of IPOs brought to market when a particular market sector is “hot” with investors. A smart investor will eye the percentage of stock being sold by insiders, for these shareholders know a whole lot more about the company than you do. Will insiders continue to hold a substantial stake in the company? What are the “lock-up” provisions that restrict them from selling more stock until a later date?

In general, IPOs are usually undertaken by young, fast-growing companies with a short track record, thus the high risk level. A minority will manage to turn into large companies, but the list of failed or underachieving IPOs is much longer.