Wealthsimple is a whole new kind of investing service. This is the latest installment of our “How To” series, where we lay out smart and easy-to-understand advice on navigating the financial world.

2019 tech IPOs: they’re huge. They’re enormous. They’re gigantic. They’re other synonyms for big. By the end of the year Lyft, Pinterest, Slack, Airbnb, Beyond Meat (which, even though it's food, we consider tech because why not) will all have gone public. Uber’s IPO was a cultural event, like the Game of Thrones finale or the Super Bowl. (OK, more like a divisional playoff.)  It almost feels like the year 2000, that last frothy moment of the dot com bubble. (Maybe you weren’t born yet, in which case: good for you 15 year olds who are reading financial journalism! You’re on your way!) It’s all enough to make you, average investor, think you could strike it rich. It’s all enough to give you a case of financial FOMO so extreme that you’re going to jump on Wealthsimple's Trade app on IPO day and buy buy buy.

But even while the technology fueling these companies and products and super animal-y tasting non-meat is new, the phenomenon of the IPO itself isn’t. And the principles underpinning how IPOs work aren’t different than they were back in the days of Pets.com (if you don’t know, don’t ask). For anyone even thinking about buying stock in one of these companies, it's crucial to know how IPOs work.

So before you go all in on Palantir (a data mining company, and/or the plot of a dystopian science fiction film centered around facial recognition — one or the other) later this year, here are a few things to understand about how it all works.

Why Do Companies Have An IPO?

There are three big reasons most companies go public:

Raising capital: this is the big one. Going public is an effective way to get more money for your company so it can grow, innovate, and make things taste more like pork (Beyond Meat). When companies sell shares, they effectively allow investors to give them money as a kind of wager on their future value. And a coordinated, much-publicized event means the company has the ability to generate interest, both from financial institutions and the public.

Rewarding private investors: Venture capitalists, early investors, rich uncles — lots of people can put money into a company early on to help the business get on its feet — and this can be their time to turn that early faith into cold hard cash (or easily sellable stocks). As you can imagine, IPOs are especially popular among those who can make lots of money from them.

Rewarding employees: When you start working for a new company that doesn’t have a ton of cash, the company often pays you in the promise of future rewards. In this case: stock. That stock is usually valueless until the company goes public, when employees are free to sell their vested shares. So it’s not so different from investors — early faith is paid off handsomely, or at least that’s the hope.

What Does a Company Have to do to Have An IPO?

OK, so, there are steps. When a company thinks it will be attractive to the investing public (or will someday be) it usually lines up an underwriter in the form of a typical Wall Street bank — Morgan Stanley for instance. The underwriter will begin the process of determining the number of shares the company might offer and the price of each share. They’ll work with company leadership, lawyers, accountants, and venture capitalists to put together a registration statement — known as an S-1 — which has all sorts of information about the company’s goals and the inner workings of its finances. Then they go out and sell.

That’s called a “roadshow” and it involves going before audiences of institutional investors, nationally or globally, and presenting the IPO to them, and getting immediate feedback. Sometimes potential investors balk at the price, or object to how much stock is being offered. The underwriters compile all this feedback and use it to help determine the price and number of shares. They then begin taking commitments from these institutional investors. Generally, underwriters price the stock a little lower than they think it’s worth, so investors who commit to these shares have the chance to immediately sell them to the secondary market — i.e., public stock exchanges. It’s a reward for taking an early risk on a stock that no one knows much about.

Why You, the Non-Institutional Investor, Probably Won’t Get the IPO Price

IPOs are complicated investments. And that's partly because when you buy on day one, you’re often already too late. (We’ll explain later.) Here’s why.

In most cases, the shares that are selling for the initial offering price are all scooped up before the stock market bell ever rings. All those investors, employees, institutional investors, and the wealthy clients of large firms get the first crack, and if the IPO is a good one, they’re all sold out.

That often means that if you’re a regular investor the first chance you have to buy the stock will be at a price that’s already risen from the IPO price. A lot of stocks experience a pop in price right after they begin trading, and this is how those large institutional investors can make a killing — they can immediately “flip” the stock by selling to non-insiders and make a big profit. According to Jay Ritter, a finance professor and IPO expert at the University of Florida, between 1980 and 2018 the average first day return for a company that was IPO'ing was 18%. That means if you're buying shares on day one in the secondary market, on average you paid 18% more than what the company actually sold itself for.

“Investors who are able to subscribe to the IPO at the price that the company is selling its shares often see a nice return in a very short period of time,” says Daniel Tersigni, a CFA and Wealthsimple portfolio manager. “It’s the folks who are buying it from them on the market who tend to do poorly over the longer term.”

When Should You Actually Invest in an IPO?

This one’s easy (and also extremely difficult). You should buy shares in an IPO for the same reason you would buy shares in any company: because you think the future value of the company is greater than the price its shares are currently trading. Knowing that is difficult for any stock (otherwise people would be better at picking individual stocks; research suggests we're all pretty bad at it, even professionals). But it can be even harder for an IPO. It’s the first time the stock has been traded, so you don’t have a past history of the business, or its stock price, to study.

Sometimes That Initial “Pop” Is the First, and Last, Pop There Is

60% of all IPOs are lower five years after they debut. Blue Apron is a recent example of a stock that’s been declining since day one. Lyft's IPO performed so poorly investors are suing. But Twitter is a more instructive example simply because we have more data to look at. Twitter IPO'd in November of 2013, selling its shares for $26 each. There was an early pop in the share price, and in the first few days of trading, it increased a lot. Now, five-and-a-half years later, the shares are just slightly below $40 — an increase of 54%. Not too shabby, right?

But if you bought Twitter on the market on the first day of trading, you'd have had to pay about $40 right away, because you were buying it on the secondary market. It closed day one in the low $40s, and right now it's slightly less than $40 a share. The early subscribers would’ve made money. But regular folks who bought it on the market the first day have essentially seen a small loss over the life of the stock. During that same period the S&P 500 has increased considerably. You would be much better off if you had invested in an index fund — or even kept that money in a savings account. (Over half of stocks perform worse than a savings account.)

And Then There are IPOs That Don’t Pop At All

Around a quarter of IPOs lose money on the first day. Companies can generate a huge amount of heat and interest and sell all the shares, but once they start trading the price may drop.

Just check out what happened on Uber’s first day.

How Do You Decide If You Believe In the Future Prospects?

Well, you could start by doing the same kind of research institutional investors do. You can look at the company’s SEC or OSC filing (the S-1 we discussed above). Here’s the S-1 that Uber filed in advance of their IPO. This document details how the company makes money, what its future plans are, what the risks to that plan are, etc. Filings are dense, but they’re revealing if you know what to look for. And if you know what to look for, you’re probably either in the industry or covering it in the media. (New York magazine recently scoured Uber’s filing and listed what it thinks are some warning signs for the company.)

“If you're not an expert on actually understanding financial statements or willing to dig into those documents, then you're operating at a disadvantage from the start,” says Tersigni.

Is It Ok to Buy Some Shares in a Company That Just IPO’d Anyway (and When and How Much Should it Be)?

If you do invest in an IPO, our portfolio managers at Wealthsimple generally suggest you keep the investment — and any investment in individual stocks — as a small percentage of your portfolio. As in: an amount of money you’d be OK with losing. And only to make those types of investments once you've maxed out all of your tax-efficient capacity (like a 401k in the U.S. and an RRSP in Canada) and are investing plenty of money in a smart, low-cost, diversified strategy. If you’re going to buy an IPO because you believe in the story of the company or just because you're caught up in the excitement or the fear of missing out, recognize — well, it's speculative.  

And fun!

(But mostly speculative.)

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