The initial public offering (IPO) of a company is the day that it lists on the stock exchange for the first time. The company was privately held, but now it is available to the public!
Here’s how it works. The investment banks arrive at a valuation on the company that makes sense. They then set a price for the new stock that they think is fair to both the company and the buyers of the inside allocation of stock for the first day. This is a delicate balancing act and tough job for a bank, because they have two parties with opposing desires that have to come together here. The company wants a stock to list at $40/share (for example) and get the richest valuation they can on the first day. The investors that will be agreeing to own the stock on that first day want the stock to list at $12/share knowing that it’s probably worth a ton more than that. Why? They want to own it at $12 and see it open trading at $25 or $35 and make huge bank, that’s why!
Eventually, the parties all come together on the appropriate price, and the deal is ready to list. The “book” is being put together, and stock is being allocated and subscribed, and the pricing might be around $25 for our example. Now, nobody knows how the overall street of investors are going to react. They may hate it, and there is little to no buying on that first day. In that instance, the stock trades lower. Or investors might find that there is huge demand, and the first trade higher than the IPO price. It may just ramp on up to $35 very quickly. Wow, everyone wins. The company has its cash – they may have sold 30 million shares at $25, so they have their $750,000,000 in cash now in the bank. The initial investors are happy - they bought at $25 and it closed at $35 and they’re in the money.
Next, how do people make money on IPO’s? If you’re a preferred customer at a major firm that is part of the IPO process, then maybe you get some small amount of stock on the offering. Most of the IPO stock goes to the big funds: the hedge funds, the mutual funds, the institutional players. They get that advantage because of all the trading business they give the firms. They get this candy and we don’t.
The way the insiders make money is they get 10,000 shares of XYZ stock on the IPO at $20. The stock opens at $35 first trade – and the client is in the money $15/share or $150,000 on an investment of $200,000. Nice day. That client has every right to sell it right then and bank the profit.
Again, to get this candy and these returns, you have to be a big customer of the firm. Meaning, you have to have an account, say at JP Morgan Chase, and have $50 million in assets there. You have to do a ton of trading at full commission and be paying the bank $1 million in fees a year for them to even consider giving you 10,000 shares of a hot stock. The odds of that are not good for most of us, right?
So, we have to find another way to play. It will never be as good as being the insider that gets the beefy allocation of the hot deal, but we have our ways to get in the game.
How can Carnivores make money on IPO’s if we don’t get “allocations” of the stock from our firms? The stock goes IPO, but before it goes, we’re looking at it and deciding if it’s “our kind of company.” Is it in the right space? Do they have top product or management? Is this of any interest? Many are not. But, as an example, if it’s a cloud-based software company in an interesting space, it has some size, it has great customers, then we take note. We watch the first day of trading, and even if it trades up, we can buy it. In the right market conditions, we might see it go public at $25 to the insiders that got the allocation, it opens at $35, and trading is active. We look to see if there is a good bid under it, and then we can buy it with the hope that it might follow through to $50 or $70 or $125. In other words, we trade it like a normal stock.
