In the sometimes mundane world of investing, initial public offerings are shrouded in mystique.
The world of newly public companies, after all, remains off limits for most individual investors, although that is slowly beginning to change.
Apart from the sex appeal and the potential for big returns, however, investing in IPOs is risky business. One simple fact anybody interested in jumping in the new issue market should know: Year in and year out, IPOs have historically underperformed the broader market.
Obviously, investors need to get beyond the allure and hype of IPOs and become educated about the facts.
Following are some definitions of terms commonly used in the IPO market.
American Depositary Receipts (ADRs) — These are offered by non-US companies wishing to list on a US exchange. They are called “receipts” because they represent a certain number of a company’s regular shares.
Aftermarket performance — Used to describe how the stock of a newly public company has performed with the offering price as the typical benchmark.
All or none — An offering which can be canceled by the lead underwriter if it is not completely subscribed. Most best-effort deals are all or none.
Best effort — A deal in which underwriters only agree to do their best to sell shares to the public, as opposed to much more common bought, or firm commitment, deals.
Book — A list of all buy and sell orders put together by the lead underwriter.
Bought deal — An offering in which the lead underwriter buys all the shares from a company and becomes financially responsible for selling them. Also called firm commitment.
Break issue — Term used to describe a newly issued stock that falls below its offering price.
Completion — An IPO is not a done deal until it has been completed and all trades have been declared official. Usually happens about five days after a stock starts trading. Until completion, an IPO can be canceled with all money returned to investors.
Direct Public Offering (DPO) — An offering in which a company sells its shares directly to the public without the help of underwriters. Can be done over the Internet. Liquidity, or the ability to sell shares, in a DPO is usually extremely limited.
Flipping — Buying an IPO at the offering price and then selling the stock soon after it starts trading on the open market. Greatly discouraged by underwriters, especially if done by individual investors.
Greenshoe — Part of the underwriting agreement which allows the underwriters to buy more shares — typically 15% — of an IPO. Usually done if a deal is extremely popular or was overbooked by the underwriters. Also called the overallotment option.
Gross spread — The difference between an IPO’s offering price and the price the members of the syndicate pay for the shares. Usually represents a discount of 7% to 8%, about half of which goes to the broker who sells the shares. Also called theunderwriting discount.
Indications of interest — Gathered by a lead underwriter from its investor clients before an IPO is priced to gauge demand for the deal. Used to determine offering price.
Initial public offering (IPO) — The first time a company sells stock to the public. An IPO is a type of a primary offering, which occurs whenever a company sells new stock, and differs from a secondary offering, which is the public sale of previously issued securities, usually held by insiders. Some people say IPO stands for “Immediate Profit Opportunities.” More cynicIt’s Probably Overpriced.”
Lead underwriter — The investment bank in charge of setting the offering price of an IPO and allocating shares to other members of the syndicate. Also called lead manager.
Lock-up period — The time period after an IPO when insiders at the newly public company are restricted by the lead underwriter from selling their shares. Usually lasts 180 days.
New issue — Same as an IPO.
Offering price — The price that investors must pay for allocated shares in an IPO. Not the same as the opening price, which is the first trade price of a new stock.
Opening price — The price at which a new stock starts trading. Also called the first trade price. Underwriters hope that the opening price is above the offering price, giving investors in the IPO a premium.
Oversubscribed — Defines a deal in which investors apply for more shares than are available. Usually a sign that an IPO is a hot deal and will open at a substantial premium.
Penalty bid — A fee charged to brokers by the lead underwriter for having to take back shares already sold. Meant to discourage flipping.
Pipeline — A term used to describe the stage in the IPO process at which companies have registered with the SEC and are waiting to go public.
Premium — The difference between the offering price and opening price. Also called an IPO’s pop.
Prospectus — The document, included in a company’s S-1 registration statement, which explains all aspects of a company’s business, including financial results, growth strategy, and risk factors. The preliminary prospectus is also called a red herringbecause of the red ink used on the front page, which indicates that some information ? such as the price and share amounts ? is subject to change.
Proxy — An authorization, in writing, by a shareholder for another person to represent him/her at a shareholders’ meeting and exercise voting rights.
Quiet period — The time period in which companies in registration are forbidden by the Securities and Exchange Commission to say anything not included in their prospectus, which could be interpreted as hyping an offering. Starts the day a company files an S-1 registration statement and lasts until 25 days after a stock starts trading. The intent and effect of a quiet period have been hotly debated.
Road show — A tour taken by a company preparing for an IPO in order to attract interest in the deal. Attended by institutional investors, analysts, and money managers by invitation only. Members of the media are forbidden.
Selling stockholders — Investors in a company who sell part or all of their stake as part of that company’s IPO. Usually considered a bad sign if a large portion of shares offered in an IPO comes from selling stockholders.
S-1 — Document filed with the Securities and Exchange Commission announcing a company’s intent to go public. Includes the prospectus; also called the registration statement.
Spinning — The practice by investment banks of distributing shares to certain clients, such as venture capitalists and executives, in hopes of getting their business in the future. Outlawed at many banks.
Syndicate — A group of investment banks that buy shares in an IPO to sell to the public. Headed by the lead manager and disbanded as soon as the IPO is completed.
Venture capital — Funding acquired during the pre-IPO process of raising money for companies. Done only by accredited investors.