Six Things to Know Before You Buy an IPO

Investors dream of getting in on the ground floor of the next IBM, Intel or Xerox -- buying a thousand shares of stock on its initial public offering at $20, watching it split two, three or four times and ending up with 16,000 shares at $100 per. Or even buying an IPO at $20 and selling it a week later at $60.

But finding the next Yahoo can be like voodoo. The road to such glory is dangerous, with losers all around. And worse yet, the access ramps are difficult to find. That said, here is a road map.

The Basics of the IPO

An IPO is a company's first offering of shares to the public. It is the first time those shares will be given a test of their market value. Before the IPO, the company (and its underwriters) has set a price for the shares based upon their belief (or wish) as to their value.

The price is more a reflection of the amount of capital the company is looking to raise than of the actual "book value" of the shares. On the IPO date, and soon thereafter, the market will set value, as it does with all stocks, based on the price investors are willing to pay.

A Good IPO Is Hard to Buy

Unfortunately, getting some of those shares at their initial price is nearly impossible for individual investors. Large institutional investors, such as mutual funds and pension funds, get the bulk of the offering-price allocations. The small investor and her broker are at the bottom of the food chain. However, if you know where to look you can break in sometimes.

The Right Broker is the Key

In selecting a broker for IPO access, select a firm that underwrites many deals. The more deals, the more inventory and the better chance of you getting an "allocation." For technology issues, Robertson Stephens, Montgomery or Alex Brown do many underwritings. For other sectors, Morgan Stanley, Merrill Lynch and Lehman Brothers are the big players.

But be aware that most of these brokerage firms will not allow an IPO as your first investment with them. You must have an established, active account.

Also, be alert to new brokerage developments. For example, Fidelity has announced a deal with Salomon Brothers in which 15 percent of Salomon-managed IPOs will be made available to Fidelity. Try some of the smaller houses that make it their business to have an IPO inventory.

IPO Mutual Funds

Renaissance Capital is starting an IPO mutual fund that invests just after the company is listed. Renaissance is the leading source of institutional research on IPOs. Two other funds, Wasatch Micro-Cap and Robertson Stephens MicroCap, are established IPO funds with good performance. Two small firms, Wit Capital and W.R. Hambrecht and Co., will let you bid for a small number of shares online.

Before You Buy an IPO

1. Read the prospectus; a copy will be mailed to you on request. The most important factors to consider are the proposed uses of the money raised and the plans of the present insiders. If the money is going to repay loans or buy the equity of the founders, look out. If it's going for research, testing, marketing or other operational items, good. If present management is staying on, also good.

2. Read Monday's USA Today to learn what IPOs are coming.

3. Ignore hype or tips; if your broker suggests an IPO, your antennae should go up. There is a reason the shares are plentiful, and it's not good.

4. Look for spin-off IPOs; when larger companies divide, such as Lucent from AT&T, chances are there is profit to be made on parent and offspring alike.

5. Look for the major underwriters; small underwriters may signal a reluctance on the part of Wall Street to stand by a new company.

6. My suggestion: Wait. There is no stock that you simply must own. Let the market work for a day or two before you take the plunge. You will win that way more often than you will lose.

If you wait 6 to 24 months after the IPO, you can buy the stock from any broker and probably at a great discount below or near the original IPO price. Why?

IPO prices usually go down, significantly, even if the company is excellent. The secret is that venture capitalists, principles or the parent company for spin offs agrees to wait anywhere from six months to two years before they sell their shares. This is called the lockup period. When they finally sell off, the "dumping" takes its toll on the stock price, and you get in at or near the original offer. Of course, the stock is already listed, so any broker can make the trade.
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