Nothing may be more exciting than a new stock entering the public markets. Financial media will cover its every move as Wall Street scrambles to get a piece of the young, sexy company that tells a great story. We’ve seen it all plenty of times before.

Most companies enter the stock market through an initial public offering or IPO for short. Since 2000, there have been over 6,000 IPOs. During periods of market exuberance, more companies will pursue IPOs to take advantage of investor excitement, while in bear markets, very few will come out. In 2021, over 1,000 companies started trading on the stock market through an IPO. In 2008 – the worst bear market of the century – there were only 62.

Even though the IPO is a popular route for a company to enter the public markets, investors think there are flaws with the process. Here’s a quote from venture capitalist Bill Gurley:

“In the past three years, it’s gotten worse, and I think that’s because the IPO process has devolved … it used to be that the IPO process was about disseminating and marketing and selling far and wide, and it’s become a game of just hand-allocating shares to the same 10 or 15 firms.”

Individuals who read this quote will undoubtedly have some fears about investing in IPOs. But are they right to have this fear? In this post, we’ll try to figure out if the modern IPO process is scamming individual investors, even if it may not be in the way the venture capitalists think.

This post will cover:

• How IPOs work
• Are IPOs safe to invest in? And are they a scam?
• What is a lock-up period? And why it matters to you
• How to invest in IPOs (the right way)
  

How IPOs work

An initial public offering is just what its name says: the first offering of a company’s shares to a public stock exchange. Before an IPO, a company is considered private with a few shareholders (typically the founders, employees, and large investor groups) that are not freely available for trading.

If a company wants to transition from a private to publicly traded stock on a major stock exchange, it must first file paperwork with all its financials to the Securities and Exchange Commission (SEC).

After getting all its documents in order, the private company advertises and markets itself to various investment banks. In the IPO process, the company wants to find a bank – such as JP Morgan, Goldman Sachs, or others – willing to underwrite the IPO to Wall Street. These are called the underwriters, unsurprisingly.

Underwriters go to Wall Street and big investors to find interest in the IPO shares that will be offered to the public and at what price people are willing to buy. They then take this information back to the company and settle on an IPO price.

What’s next is the fun part: the actual offering to the public. The company will set an IPO date after finding investors willing to buy at the IPO price, and shares will start trading on the public stock exchange.

Sometimes, a stock will experience an IPO “pop,” as they call it, and shoot up massively on its first trading day. For example, in 2020, Airbnb’s stock popped 112% on its IPO day during the pandemic bull market.

So, where do individual investors come in? Rarely will a brokerage allow individuals to participate in the initial stock offering of the IPO. However, typically, individuals are only allowed to buy shares of an IPO after it starts freely changing hands on the public markets.

Are IPOs safe to invest in? And are they a scam?

Venture capitalists and the financial media like to make IPOs seem enticing but also dangerous to invest in. Some, like from our quote in the introductory paragraph, even call them broken and a scam. While I don’t think calling them a scam is accurate, there are some dangers for individual investors to look out for.

For one, let’s address what venture capitalists complain about in the above paragraph. Given the frequency of IPO “pops” on the first day of trading, private investors feel like they are consistently short-changed by the investment banks that profit from these IPO underpricings.

While they may have some realistic gripes as private investors, most of you will never run into this issue as individual saves. This is especially true because as individuals, we likely have little access to own these private companies before they go public or buy the pre-IPO share allotments, making the IPO pop irrelevant to us.

What matters to an individual is what happens after the IPO. Frankly, the numbers don’t look good. According to a study, new stocks perform around the same as the market average in the first weeks, months, and even six months after the IPO day.

However, after one year, and especially three years, IPO stocks begin to severely underperform the market average. In fact, after three years, 64% of IPO stocks trail the market by 10%, according to a recent study by the Nasdaq Stock Exchange.

So what happens? How can such a large group of diversified companies underperform the market for multiple years?

From my seat, it all comes down to one influence: the lock-up period.

What is a lock-up period? And why it matters to you

The lock-up period is a small rule hidden in most IPO documents, but it can have a large sway on a stock’s price movements by restricting the number of shares allowed to be bought and sold on public exchanges.

To prevent companies from dumping worthless shares onto the public, investors and executives in IPOs will generally sign extended lock-up periods that prevent them from selling their stakes after the IPO process. This is typically a 90-day or 180-day period that freezes these shares from getting sold on the public markets.

If—due to these lock-up agreements—only a small percentage of a stock’s shares are floated for public trading, this can mean a tiny number of shares are chased by a lot of eager investor dollars. It doesn’t take a rocket scientist to see that this can keep a stock price irrationally high as public market buyers clamor to buy just a few available shares of the stock.

As the lock-up period ends, this cycle can unwind as the rest of a stock’s outstanding shares hit the open markets. This added selling pressure from insiders can cause a stock price to slide significantly as the company exits this lock-up period.

For example, if you look at Coupang, a major IPO from 2021, its shares slid for a long time in late 2021 and 2022 after its major shareholder, Softbank, dumped billions of dollars of stock. After this ended, the company’s stock regained its footing and is starting to follow the underlying business trajectory.

There isn’t any other explanation needed for widespread IPO underperformance. When a stock enters the market through an IPO, it has an artificially low number of shares traded, which drives up the stock price. When this ends, the stock price generally falls.

How to invest in IPOs (the right way)

So, how does an individual investor safely invest in IPOs?

Easy. You don’t. Due to the restrictions on investing in companies before the IPO and the headwinds presented by the lock-up periods, the odds are stacked against individuals trying to get in on IPO stocks. Smart investors understand this dynamic and avoid new entrants to the public markets.

Instead, if you see a company you like go through an IPO, keep it on the watchlist. You can likely buy the stock at a lower price once the lock-up period ends.

Take our Coupang example again. After the post-lock-up period selling ended, the stock began to recover, and the business is thriving. Its shares are up 55% since the start of 2023. Even if you were a fan of Coupang’s business in 2021 when it went public, smart investors understood that there would be immense selling pressure when the lock-up period ended.

Anyone who waited to buy until a year or two later was able to scoop up shares of the same business at a much lower price when Coupang shares fell well below 50% off its all-time high.

As individuals, we don’t have the power to change how the IPO process works. But we can understand how it affects stock prices to be smarter and safer when buying stocks for our retirement accounts.