Don't invest in an IPO without reading this!

23 November 2021 @ 12:00am IPOs

Written by Cassandra Diamantis, Marketing Manager at OnMarket. 

Historically, IPOs were only offered to institutional and “high net worth” investor clients of brokers. But times have changed! With OnMarket, retail and self-directed investors have access to private capital raisings, listed placements, and IPOs!

So, the million-dollar question: What questions should you ask before investing in an IPO? And how can you avoid IPOs that are unlikely to succeed?

Reading the IPO prospectus is always the best place to start, but understanding which parts are the most important will help you to break down the content heavy prospectus – resulting in better informed investment decision.

Here are seven tips on what to look for BEFORE investing in an IPO.

Tip #1: Understand the business and opportunity

Investment guru Warren Buffett attributes his success partly to remaining within his “circle of competence”. If he can’t completely understand what a company is doing, he believes it is very likely that other people have the same difficulty – therefore, he avoids investing. And he’s right.

It is simple but integral advice – and certainly something to consider when investing. If you don’t understand the business then remember: it’s not you, it’s them. Companies should be clear in the prospectus about:

• What their product or service is
• The problem they are solving
• The gap in the market they are filling

Once you understand the business, identifying the market opportunity is your next step. The size of the opportunity, and the company’s ability to capture market share, can make a significant difference when it comes to growth and shareholder returns. Pro Tip: always keep in mind that the size of the market is only an estimate.

Tip #2: Understand the risks involved

Investing in the stock market always brings a certain level of risk. Given the broad range of companies across industries who IPO, and the experience of each of these companies, understanding the risks associated with each specific business is an important pre-investment step.

The current market environment, number of competitors, and quality of the product or service will all play a role in this. Company specific risks are found in the prospectus. You should read these carefully prior to making an investment.

Tip #3: Research the company’s management team

Take a close look at the list of people listed in the prospectus as directors and managers. The track record of those in charge is vital. Do they have prior experience in the industry? How long have they been with the company? How much are they being paid? How well rounded is the board?

Do your due diligence on them, including a Google and LinkedIn search. One piece of negative press may be a blip or a misunderstanding, but several negative pieces may be a red flag. Also, keep an eye out for the less obvious. As an example, some small companies combine chief executive and executive chairman roles, which does save money but leaves a lot of power with a single person.

Tip #4: Understand the capital structure

Existing shareholders and the level of ownership that key management personnel (CEO, chairman & directors) have should play a significant role in your investment decision.

Having well-known investors and directors with sizeable ownership in the business should be an encouraging sign. Why? Because they are more likely to be focused on the long-term success of the company. Please note, this doesn’t mean that if management own fewer shares the IPO isn’t good, it just may imply more research is required.

Be on the lookout for things like options and performance shares. Every new share will impact your holding and some of these may be triggered upon listing. This is important for the future of the business and the true value of your shares.

 Look for owners who are keen to retain ‘skin in the game’. How much of a stake are they retaining in the company after the IPO, what does the escrow agreement look like and how many options are included in the offer?

Tip #5: Know the reason for listing and the use of funds

Companies going public and seeking to raise funds from investors should include a clear statement in the prospectus about how the money will be used.

Understanding where your money is being spent should be important to you and will play a role in the performance of your investment. Companies that put the funds raised back into the business will have a greater incentive for the business to grow.

Importantly, keep a sharp eye out for anything that will benefit third parties, such as excessive fees being paid out to advisors, as occurs in some floats.

At high level, companies putting funds towards growth initiatives are more likely to have a greater long-term outlook. Therefore, providing a more stable investment.

Tip #6: Review the financials and the valuation

Sound financials are a crucial element in the long-term success of the business. This will give you an indication as to how the company is using available capital, and the historical growth of the business.

The financials will also play a role in the company’s valuation. If a company is considered overvalued at IPO, it may decline upon listing, thus your investment may be better placed once the shares are trading. To determine whether the company is fairly valued, review similar listed companies and compare its:

• Growth potential
• Company management
• Competitive advantage

Tip #7: Research the lead manager or broker

As a general rule of thumb, quality lead managers and/or brokers bring quality companies ‘public’. A company floated by a reputable lead manager/broker provides the added comfort that robust due diligence has been conducted on the prospects of the company. But remember, there is no guarantee for success.

Along the same lines, it is always wise to review the number of adviser and broker shares that will be issued, what the escrow period is (time period required before the new shares can be sold), and performance hurdles applied to these shares.

Use these 7 tips as your mandatory investor guide for IPOs. To put your newly found knowledge in action, check out OnMarket’s live deals.