IPO investing is a risky game that requires a special type of due diligence. Remember that when you get involved in IPOs you’re putting your chips on the table with some of the biggest movers in the marketplace: the Wall Street investment firms that launch the IPOs, a slew of Wall Street traders looking to get in and out for quick gains, institutional investors, and of course independent investors.
Because the big money is really made in the underwriting process, IPO investors should understand the underwriting process, at least at a basic level.
There are a couple of different methods. Investment banks can either underwrite the IPO on a firm commitment or best-effort basis.
The difference is critical to understand because it suggests the level of confidence the underwriting firm has in the potential for share price appreciation. If you’re a poker player, consider this to be the underwriting firm’s “tell.”
If the investment bank does a firm commitment offering, they purchase shares from the company and then attempt to resell them to institutional and individual investors at the full public offering.
Investment banks usually purchase these shares at a discount, and profit from the spread between the purchase price and their resale price (usually around 7%). By buying the shares, they take on some of the risk.
In sharp contrast to the firm commitment offering, the best-efforts offering doesn’t require an underwriting firm to purchase shares.
In this scenario, the investment bank agrees to give its “best efforts” to sell some predetermined number of shares, within a minimum and maximum range. If the investment bank falls short of this range, it can simply return the unsold shares to the issuing company.
In other words, the underwriting firm is not on the hook for getting all the shares out the door.
The question you should ask is this: If the underwriting firm isn’t confident in the potential to sell all the shares, do you want to buy any?
Investment banks are generally full of pretty darn smart people (despite the problems they’ve gotten into lately).
If these guys are not willing to take on the risk of buying shares because of uncertain demand, you want to pick up on the “tell” signal – and may want to pass on the stock