Getting a piece of the action of a hot IPO can be very difficult. The mechanism of how this works can be somewhat complex, put simply it’s the number that balances supply and demand.
Company “A” needs to raise money and therefore decides to do this via an IPO. For the founders of “A”, the upside is they become a wealthier company and can use the money to become better and more profitable. The downside is that the founders stake in “A” goes down. How do the founders find a solution for this trade? They calculate the number of new shares of “A” they wish to issue, and the price they set per share they wish to sell.
The founders of “A” evaluate how much of the company they wish to retain and how much they wish to sell off. The company is then advertised and offered to institutional investors via its underwriting bank(s), which then invite the investors to submit requests for how many shares they wish to buy, deemed as pre-IPO stocks. Institutional investors are important clients of the underwriting bank(s), comprising of pension funds, mutual funds, and hedge funds.
Why do these investors get in on the act before the general public? For reasons of stocks price stability which is a general rule of the underwriting bank(s), and of course due to their deep pockets and the capacity to take risk. Analysed practically, these institutional investors as well as the bank(s) are in it to make profit on their investment into “A”, large ones at that, leading some to cash in by selling a portion or all of their shares on the day “A” stocks is offered to the public.
Once the shares portion of “A” have been sold by the underwriters to the institutional investors, “A” goes to market, listed on one of the stocks exchanges. On the morning of the first day of listing, orders start to come in from all over the world, consisting of both retail and other institutional investors who were not offered pre-IPO stocks.
The “Market Maker” which is the bank, will begin to collect the orders and evaluate the inbound numbers and then report the share price in the media. The “Market Maker” will set the opening price, which is selected so that supply and demand are balanced. In practical terms, the opening price that maximises the number of trades based on the orders thus far. The “Market Maker” then freezes the price and blocks further orders; this is generally known as the “discovery” period and generally takes place in less than 30 minutes or in the case of a high profile IPOs where there is greater market anticipation, up to an hour.
The shares are then released to the public, and at the close of business on the first day of trading to the public, company “A” has increased its value exponentially. Of course the founders, staff, institutional and other investors who were lucky enough to be allocated or purchase pre-IPO stocks prior to the public, are now extremely excited and eager to calculate their profits at the point of market close that day, all hoping the share price increased. Should the markets have gone crazy for this stocks, these parties would have enjoyed substantial profitable gains.
Companies that make the most profits are generally the best bet stocks to buy as they are superior bets. This calculation in practical terms: gross margin is the difference between net sales of company “A” and the cost of sales, divided by net sales, measuring the core profitability.
IPOs are a great market; however it is not as easy as it may appear. Be careful in your research and seek third party advice before acting. The art to winning in the IPO market is getting in at the earliest possible stage you can and exit at the most profitable.