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You can't trade stocks for very long without hearing a hot tip about a company that is getting ready to go public with an IPO. You might hear that if you get in on the ground floor, you stand to make a killing in the market. Well, maybe. But initial public offerings, or IPOs, are by their very nature risky and speculative investments, according to the U.S. Securities and Exchange Commission.
A private company might wish to go public for many reasons. The founders might want to cash out their investment. The company's management might want to raise capital to fund expansion, research and development or to build new facilities. The company might wish to use their stock or stock options as an incentive to acquire or retain key employees.
Initial Public Offering
An initial public offering is the first time a company's stock is made available to the public for purchase. An IPO typically involves a number of underwriting companies, usually investments brokerage firms, who agree to purchase a set number of shares of the company's stock and then resell them to individual or institutional investors. The company consults with the underwriters about the specifics of the IPO, including the number of shares that will be issued, how many of those shares will be available to the public and what the initial offering price per share will be.
Acquiring IPO Shares
It can be challenging to buy shares of a hot initial public offering. Even if your broker is part of the underwriting syndicate, not all syndicate members are allocated the same number of shares. Your broker will only have a limited number of shares to sell. Clients who have a history of buying IPO shares, and those who are willing to make large block purchases, typically get first shot at the shares. Since the Securities and Exchange Commission considers IPOs to be risky investments, your broker must verify that such an investment is appropriate for you.
The stock market is a double auction market that is ruled by supply and demand. A hot IPO might have excess demand leading up to opening day, driving up the price immediately, but once the initial demand is satisfied, the price might just as easily plummet. Some IPOs include lockup agreements that prevent certain investors, such as insiders and venture capitalists, from selling their shares for a set period of time after the initial offering. The market price of those shares might drop in anticipation of the end of the lockup period.
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