When a stock is made available to the public, there’s a process in place. In some high-demand issues, the IPO process involves an allocation. How does it work?
Initial public offerings (IPOs) often get a lot of press. How well a big-name company does in its market debut can set the tone for trading in similar companies and even in the wider market.
Also, those who are able to buy shares at a company’s initial price have a chance of making a good bit of money. But as with anything stock related, the higher the reward, the higher the risk.
For retail investors who want to try their hand at IPO investing, the truth is that it can be pretty hard to get shares because most of them end up going to institutional investors. Like much else in the economy and stock market, IPO shares allotment boils down to supply and demand. Before taking the plunge, here are some things you may want to consider about how an IPO works, how IPO shares are allotted, and how to buy IPO shares.
In the IPO process, companies going public want to sell as many of their shares as they can at the highest price they can get. So, they hire investment bankers at places like Goldman Sachs (GS), Credit Suisse (CS), or Morgan Stanley (MS) to underwrite the offering and allocate shares to the highest bidders.
There are often multiple underwriters on the same IPO, and this group of investment bankers is called a syndicate. They market IPO shares primarily to institutional investors such as pension funds, hedge funds, or banks.
The part of the process where investment bankers try to sell shares is called a road show. During the road show, bankers can gauge demand for the offering and zero in on how much money they can get for shares based on the demand for a finite supply. Before the road show, bankers have only an estimated range for an IPO stock price.
In typical IPOs, about 90% of the shares will go to institutional investors, with about 10% going to retail investors. It’s not that investment banks want to cut out individual investors—it’s just that they’re trying to sell as many shares as possible, and big players have the financial firepower to buy big blocks of shares, according to Alex Coffey, senior specialist, trader group at TD Ameritrade.
Brokerages that cater to retail investors get portions of the remaining 10% of shares based on their relationship with the underwriting investment bankers. If the brokerage is part of the underwriting team, they may be able to get more shares.
“We’re talking about a much smaller piece of the pie that is ultimately going out to the retail investor,” Coffey said.
If an IPO is that of a well-known company that investors are keen to buy shares from, it can be difficult for retail investors to get an allocation from their broker’s pile of shares. When there’s more demand for shares than there is supply, an IPO is called oversubscribed. Individual investors have a better chance of getting in on an undersubscribed offering, but the risk is that demand is low for a reason, such as a company not having strong fundamentals.
“It comes down to supply and demand,” Coffey explained.
Not all brokerages use the same allocation formula. Some use a lottery system, while others base the decision on how valuable a client you are.
At TD Ameritrade, allocations are based on a scoring methodology, and eligible accounts must have a value of at least $250,000 or have completed 30 trades in the last three months, in addition to other eligibility requirements based on investment objectives and financial status.
Clients can sign up for IPO alerts (see figure 1). TD Ameritrade begins accepting conditional offers to buy about five business days prior to the anticipated effectiveness of the registration of the IPO. Such offers don’t guarantee that you’ll get shares, though.
FIGURE 1: TELL ME ABOUT IT. Want to be notified of upcoming IPOs available to TD Ameritrade clients? Set alerts by logging in to tdameritrade.com, and under the Research & Ideas tab, select Alerts > Equity New Issues and then Equity IPOs. For illustrative purposes only. Receipt of an alert does not guarantee participation in an offering or an allocation of shares.
“It is important to note that your ability to obtain shares of any new issue security may be significantly limited because overall demand for the IPO may far exceed the actual supply of shares coming to market,” according to the TD Ameritrade website. “After the IPO has been issued, shares will begin trading on the market shortly thereafter. Most investors will be able to access those shares more readily.” Learn more about trading new stocks on the TD Ameritrade website.
This is a discussion you may want to have with yourself: Do you want to try to jump through hoops to get into a stock right off the bat in an IPO? Or do you want to wait until it starts trading and maybe see how things shake out over the course of its first few trading days, weeks, or quarters?
One advantage of investing in an IPO can be that you get in at a price that ends up being below the price at which shares begin trading in the secondary market (meaning on stock exchanges). That can happen when there’s lots of demand from investors in the secondary market even if shares are expensive. It can also be the case that the investment bankers and the road show end up underpricing an IPO, offering what many may perceive as a bargain.
During last year’s busy IPO market, newly listed companies saw an average first day return of 38%, according to Nasdaq Economic Research. From 1960 through 2020, the average “IPO pop” was 17.2%, according to research from the University of Florida. If you bought in to one of those at the IPO price and simply sold it at its closing price, you could pocket a tidy sum—assuming you weren’t subject to a holding period.
But there’s also the risk that IPOs flop on their first day. Take Uber Technologies (UBER), for example. It was one of the most anticipated IPOs of 2019, but its shares lost more than 7.6% on its first day. Home security company ADT (ADT) lost 11.5% in its 2018 debut, and China Petroleum & Chemical Corp. (SNP) lost 4.4% on its first day of trading in 2000.
Sometimes stocks can pop on their first day only to subsequently sag. Take Lyft (LYFT). Its March 2019 IPO price was $72 per share. It closed at $78.29 on its first trading day but fell about 20% during the week of April 8, 2019.
Sometimes it can be better to just keep your powder dry and wait to see how market conditions and demand for a newly public company’s shares shake out. This is particularly true if, as an investor, your objectives tend to keep your focus on fundamentals rather than narrative, potential, or hype.
Perhaps the IPO page on the Securities and Exchange Commission (SEC) website put it best: “An IPO gives the investing public an opportunity to own and participate in the growth of a formerly private company. By their nature, however, IPOs can be risky and speculative investments.”
Like any investment, it’s a good idea to research any company that is planning to IPO to determine if it aligns with your financial goals. This isn’t always the case, and newer companies in unproven industries can require more research to fully understand their businesses and risks.
Some ways to do this before investing in an IPO include reading the SEC Form S-1 before shares are listed, finding out the length of the lock-up period—that is, how long insiders are prohibited from selling shares after the IPO—and checking whether there’s a holding period that keeps IPO investors from selling shares soon after a debut (a practice called “flipping”).
Also, as with other types of investing, consider doing a gut check to make sure you’re not getting so caught up in IPO hype that you lose sight of the prudent investing strategies you may have adopted and found to work for you in the past.
Before investing in an initial public offering, be sure that you are fully aware of the risks involved with this type of investing. There are a variety of risk factors typically associated with investing in new issue securities, any one of which may have a material and adverse effect on the price of the issuer’s common stock. For a review of some of the more significant factors and special risks related to IPOs, we urge you to read our Risk Disclosure Statement.
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