IPO Basics: What to Know Before Investing

Stock markets with positive momentum can attract initial public offerings (IPOs) with plenty of hype. For some investors, it can be easy to get caught up in the excitement.

However, investors may want to approach IPOs cautiously and keep potential downside in mind. In recent years, some high-profile IPOs cratered soon after hitting the market.

Rushing into an IPO without conducting proper due diligence can expose investors to unnecessary risks. Before making any investment, investors should conduct thorough research and have a risk management plan in place.

Here are a few IPO basics to help keep information—not hype and headlines—at the center of the decision-making process.

An IPO is the process through which a private company offers shares to the public for the first time. Companies often use IPOs to raise capital, provide liquidity for existing shareholders, or increase their public visibility.

The journey from a private company to a publicly traded one typically takes several months and follows a few major steps:

1. Hiring underwriters. The company hires underwriters to manage the IPO process from start to finish. These underwriters conduct due diligence on the company, prepare regulatory filings, and help set the initial offering price.
2. Registration. The company files a registration statement with regulators, signaling its intent to go public. The statement includes important disclosures and a preliminary prospectus that details financial information, business plans, and more.
3. The "Roadshow." The underwriters help market the stock to institutional investors, gauge interest, answer questions, and generate buzz.
4. Final pricing and allocation. The underwriters and company management determine the final IPO share price, and shares are allocated to institutional and retail investors who participated in the offering.

Once all these steps are complete, the stock is listed on a public exchange, such as the NYSE or Nasdaq^®, and begins trading like any other publicly traded stock.

Excitement surrounding an upcoming IPO can make it easy to focus on the potential opportunity. However, before investing, it's important to review key details of the offering and the company's financials, valuation, ownership structure, and more.

No checklist can eliminate risk, but prospective investors may want to pay close attention to the following factors before participating in an IPO:

• Preliminary prospectus. Also known as a red herring prospectus or S-1, this document filed by a company preparing for an IPO. It provides information about the company's business operations, financials, management, risk factors, dividend policy, and more. Prospective investors should carefully review the preliminary prospectus before participating in an IPO.
• Business fundamentals. Preliminary prospectuses contain lots of information, but investors may want to focus on fundamentals like revenue growth, cash flow, profit margins, and debt levels. These metrics can help investors assess the company's financial health, underlying risks, and long-term growth potential.
• Use of proceeds. Companies disclose how they plan to use the money raised by their IPO in the "use of proceeds" section of the prospectus. Reviewing this section can help investors understand whether the money raised will be used to fund growth initiatives, pay down debt, or support other business needs.
• Valuation. Investors should track the proposed valuation of a company before it goes public. Just like with any public stock, valuations can influence long-term return potential. Paying a premium for an unproven company may increase risk. Consider tracking valuation metrics such as price-to-earnings or price-to-sales ratios and comparing them with competitors and the broader market.
• Governance and voting rights. Preliminary prospectuses include information about the majority shareholders of the IPO company, as well as the voting rights investors will receive if they participate in the offering. Many modern IPOs feature dual-class share structures, where certain classes of shareholders hold more votes per share. Prospective investors should understand which class of shares they would acquire and whether majority owners would retain control after the company goes public.
• Lock-up periods. These are contractual restrictions that prevent insiders from selling stock for a specific time frame after an IPO. When lock-up periods end, the stock may flood the market, potentially pushing share prices lower. Read through the prospectus for information on lock-up periods.

Financial metrics and offering details matter, but investors may also want to consider industry and competitor trends, as well as broader market and economic conditions, when evaluating a potential IPO investment.

Even if there are no red flags in the offering details and the company has strong financials, the stock could still fall alongside its peers if it operates in a struggling industry once it hits the open market.

A company that goes public during a period of economic or market weakness can be pulled lower regardless of its business fundamentals. In some cases, companies delay their IPOs when market or industry conditions aren't favorable. Analyzing both public and private competitors can also help investors gauge the company's growth prospects and valuation.

To participate in an IPO, investors submit a Conditional Offer to Purchase (COTP)—also called an Indication of Interest—through their brokerage. This is a non-binding notice communicating an investor's interest in purchasing a specific number of shares before the stock officially begins trading. At many brokerages, the investor must also fill out an Eligibility Questionnaire, which determines whether they meet the legal and financial requirements to participate in the IPO. Once the IPO has been priced, investors must confirm their COTP to remain eligible to purchase shares.

Investors who receive an IPO allocation, which is not guaranteed, buy shares before the stock begins trading on a public exchange.

Note: IPOs are speculative investments, and Schwab cannot make recommendations to purchase IPOs. Also, when brokerages participate in the distribution of IPO shares, even secondary market trades are not marginable for 30 days.

Once a stock is public, it begins trading alongside its peers in the open market. The days, weeks, and months following an IPO often reveal whether it was priced accurately and what kind of growth prospects might lie ahead.

While it can be appealing to jump into an IPO right away, investors might consider simply waiting for a day, a few days, or longer after a company starts trading on the open market before investing. This waiting period allows interested investors to determine potential entry and exit points based on their observations and understanding of technical analysis, as well as what's appropriate for their own risk tolerance.

IPOs allow investors to gain access to companies at a pivotal point, but they also present risks. For example, after first going public, stocks often experience volatile trading due to limited trading volume and the market's attempts to assess their valuation and growth prospects. While waiting to buy after an IPO carries the risk of missing out on initial gains, sometimes a patient approach is the more prudent one.

Not every company that goes public will become a long-term success, regardless of the attention it gets after announcing its IPO. Investors who are considering participating in an IPO should take a disciplined approach by evaluating the offering details and analyzing the company's financials, valuation, and growth prospects before jumping in.