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Considering an IPO? Do your homework

Updated: September 12, 2012 6:00PM

Q. I have been offered a chance to buy shares in an IPO by my broker. I’m skeptical. I think these stocks fall in price right away. He says no promises. Also he says I pay no commission. So what should I do?

A. Great question. Let me straighten out a few misconceptions about initial public offerings. Every publicly traded company had an initial public offering in its past. That’s how shares owned by the founders are distributed to the investing public. Typically the founders don’t sell all their shares on the IPO. Who would want to invest in a company where the founders don’t believe they should be investing for the future?

The initial offering price is determined by the underwriters — investment banks that take a fee from the company for distributing the shares being sold. They look at the company’s earnings, at other companies in the same industry and at general stock market conditions. Then the underwriters set a price that they think is fair to buyers and sellers — and will allow them to sell out the entire offering. If they don’t have a sellout they will be stuck with the remaining stock, potentially costing the underwriter more than they make in fees.

It’s important to know that once the shares are sold to the public, the traditional exchange-trading markets set the subsequent price. Some IPOs go to a huge premium, even doubling in price on opening day. In fact, that was the general rule back in the era. More recently, several offerings, including the widely publicized Facebook IPO, fell in price after the offering.

Selling shareholders aren’t too unhappy when prices soar after an IPO, even though they have “left money on the table.” After all, they still own many more shares that they can sell in the future — after a “lockup” period expires, and subject to certain disclosure rules.

But if the stock price falls, those same founding shareholders — and the company — are certainly upset! That’s not only because they have lost some of their own wealth, but because may want to sell more shares in the future. Keep in mind that in future stock sales, whether by the company or by selling shareholders, the price will be set relative to the price at which shares are already trading in the open market. Those offerings are called “secondary” sales.

There is one more misconception to clear up. There definitely is a commission paid to the stockbroker. In fact, it is likely larger than the commission you would pay on a similar stock purchase on shares of a company that’s already trading. The commission is “built in” to the price you see on your trade confirmation, not broken out as a separate fee.

Now where does that leave you, the potential IPO investor? In every IPO, you must weigh the merits of the individual stock. However, despite strict rules about what companies are allowed to say in advance of an IPO, there is frequently media hype that boosts demand for the stock. You need to sort out the hype from the reality.

Ask yourself why the broker is offering you this great deal. Is it because you’re a good client? Or is the broker merely trying to place a lot of the shares and earn a big commission?

Do your homework before buying an IPO, as with any stock. The big difference with an IPO investment is that you are depending on the underwriter to determine if that initial price is right. Only after you’ve bought will the market have its say on pricing!

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