Traditionally, IPOs were only offered to institutional and “high net worth” investor clients of brokers. Now, with OnMarket, retail and self-directed investors have the opportunity to access private capital raisings, listed placements and IPOs.
So, what questions should investors be asking before investing in an IPO, and how can investors avoid those that are not likely to succeed?
Reading the IPO prospectus is always the best place to start, but understanding which parts are the most important will help you to break down the prospectus and make an informed investment decision.
Investment guru Warren Buffett attributes his success partly to remaining within his “circle of competence”. If he can’t work out what a company is doing, he believes it is highly likely that lots of other people have the same difficulty – therefore he stays away. And he’s right.
It is simple yet integral advice, and something to keep a close eye on when investing. If you don’t understand the business then remember: it’s not you, it’s them. Companies should be clear in the prospectus about what their product or service is and the problem they are solving or the gap in the market they are filling.
Once you understand the business, identifying the market opportunity is your next step. The size of the opportunity and the company’s ability to capture market share can make all the difference when it comes to growth and shareholder returns. Keep in mind that the size of the market is only an estimate.
Investing in the stock market brings a certain level of risk. Given the broad range of companies across industries and the experience of each of these companies, understanding the risks associated with each business is an important step prior to investing.
The current market environment, number of competitors and quality of the product or service will all play a role in this. Company specific risks can be found in the prospectus and should be considered prior to making an investment.
Take a close look at the list of people shown in the prospectus as directors and managers. The track record of those who are going to be in charge is vital. Do they have prior experience in the industry? How long have they been with the company? How much are they being paid? How well rounded is the board?
Do your due diligence on them, including a Google search. One piece of negative press may be a blip or a misunderstanding, but several negative articles may be a red flag. Keep an eye out for the less obvious. For example, some small companies combine chief executive and executive chairman roles, which saves money but leaves a lot of power with one person.
Current shareholders and the level of ownership that key management personnel (CEO, chairman and directors) have can be significant in your investment decision. Having well-known investors and directors with substantial ownership in the business should be an encouraging sign as they are more likely to be focused on the long-term success of the company. This isn’t to say that if management own fewer shares that the IPO isn’t a good one but may imply more research is required.
Be sure to look out for things like options and performance shares. Every new share will also impact your holding and some of these may be triggered upon listing. This is important for the true value of your shares and the future of the business. Look for owners who are keen to retain ‘skin in the game’. How much of a stake are they retaining in the company after the IPO, what does the escrow agreement look like and how many options are included in the offer?
As companies going public seek to raise funds from investors, there should be a clear statement in the prospectus about how the money will be used.
Knowing where your money is going should be important to you and will play a role in the performance of your investment. Companies that are putting the funds raised back into the business will have a greater incentive for the business to grow.
Importantly, keep a sharp lookout for anything that will benefit third parties, such as excessive fees being paid out to advisors, as occurs in some floats. Overall, companies putting funds towards growth initiatives are more likely to have a greater long-term outlook and provide a more stable investment.
Sound financials are an important factor in the long-term success of the business. This will give you an indication as to how the company is utilising its available capital and the historical growth of the business.
The financials will also play into the company’s valuation. If a company is deemed to be overvalued at IPO, it may decline upon listing and so your investment may be better placed once the shares are trading. To see if the company is fairly valued, look at similar listed companies and compare its growth potential, company management and its competitive advantage.
As a general rule, quality lead managers and/or brokers bring quality companies ‘public’. A company floated by a reputable broker provides the added comfort that robust due diligence has been conducted on the prospects of the company. Nonetheless there is no guarantee of success. Along the same lines, it is still sensible to review factors such the number of adviser and broker shares that will be issued and what the escrow period (time period required before the new shares can be sold) and performance hurdles applies to these shares.