Investing in an IPO might seem like an exciting opportunity at first. The stock market’s thrill, price volatility, and the expectation of multiplying money in a few days are some factors that pull more and more people towards stock market investments.
But when we talk about price volatility, the possibility of share prices falling is equally probable to rising prices. So, entering the stock market through an IPO may not be as rosy and profitable as it may seem. Various risks in IPO can make or break investments.
Want to know what these factors are? Read on as we discuss the different risks of investing in an IPO.
What is an IPO?
IPO refers to an Initial Public Offering. It is the process of companies listing themselves on stock exchanges to offer their shares to the public. Companies do so to raise money from the public as capital for their operations. In return, they share the company’s ownership with the public.
Once listed on the exchange, the shares are available in the secondary market for trading between buyers and sellers without the company’s interference.
IPO is often called the primary market, as transactions occur directly between investors and the issuing company. While IPOs are usually seen as opportunities to invest in a company and grow along with it, the process involves multiple risks that can lead to investors losing money, either partially or wholly. Hence, being aware of such risks is crucial before deciding to invest in an IPO.
Risk factors involved in applying for an IPO
Investing in stocks in the secondary market is also risky, given the volatility of stocks. However, investing through an IPO can seem riskier due to the following factors:
- Uncertainty of allotment
An IPO, as the term suggests, is an offer to the public. Companies offer shares to thousands of investors in the public. However, there is a limit on the number of shares available. While finalising the terms of the IPO, companies decide the percentage of ownership they are willing to give up on, and accordingly, the number of shares offered will be decided.
When there is an oversubscription of shares, all the investors who apply may not get the allotment. Sometimes, shareholders only get partial allotments. Since IPO also involves reserving a huge chunk of shares to large-scale investors, the number of shares available for retail investors may be less.
So, planning your finances based on the expected profits from an IPO can be disappointing if you do not get the allotment as per your bid.
- Inaccurate valuation of shares
The increasing market demand for stocks during IPO has an impact on the stock’s prices. It can lead to a surge in prices, causing an overvaluation of shares, though the shares are not worth so much money.
In the case of undervalued shares during an IPO, investors benefit by buying them at lower prices and increasing the worth of their investments when shares go up during market corrections. But, in the case of overvalued shares during IPO, investors lose money when shares reduce prices during a market correction.
- Lock-in periods
Some investments during IPOs impose lock-in periods. Investors can only redeem their shares or sell them in the secondary market once the lock-in period expires. The period may range from three months to one year.
Taking part in an IPO that has a lock-in period means the money will be locked in for a certain period. Investors must compromise on their liquidity and cannot rely on encashing these investments when in need. They must also continue to hold shares despite their performance in the market.
- Unavailability of sufficient data
IPOs are specific to companies listing their shares publicly for the first time. This obviously means that the shares do not have a performance record or historical data to analyse how they react to various market events, leaving investors with insufficient information.
A stock that seems strong on financial reports does not always react well towards market uncertainties.
- Extreme price fluctuations
The prices of stocks after an IPO take time to stabilise. The increasing interest of investors during the bidding dates can lead to a rapid increase in price, which may drastically fall after the bidding date. Such extreme price movements can impact the investor’s profits.
Some investors prefer investing in an IPO rather than secondary market stocks because IPO stocks have a higher potential to grow. Unfortunately, they have the same potential to fall. Hence, investors must analyse their risk appetites thoroughly and consider the various factors involved before entering the stock market through IPOs.
Two crucial factors that are significant to the success of an IPO are: The time of the IPO and share pricing in an IPO.
The time of launching an IPO must be determined after thoroughly analysing the market and investor sentiments. Also, overvalued shares can lead to the failure of an IPO.
Yes, you can sell your shares on the listing date once they begin trading on the stock exchange. However, you can sell them only if your shares do not have a lock-in period. Generally, shares reserved for retail investors do not have lock-in periods.
IPO money gets refunded if investors do not get the allotment of shares. If shares are allotted partially, the prorated amount for the non-allotted quantity will be refunded. As per the latest rule, companies must refund the amount within four days of the IPO closing date.
If the subscription for IPOs is less than 90%, the IPO must be called off. All the funds will be returned back to investors. If an IPO is undersubscribed, but the subscription is more than 90%, all the valid applicants will be allotted shares as per their bids.
An oversubscribed IPO is where the number of bids is higher than the number of shares available. Companies use a computerised lottery system in such cases to allot shares to applicants. Otherwise, they use a pro-rata calculation to allot some shares to all investors, as per their bids.