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What’s an Initial Public Offering?

In 2011 there were 330 IPOs [3] that came to market, down 30% from 2010. Technology IPOs led the way with 24 offerings but still down from 1999 when a record 212 companies issued stock for the first time. 2012 may bring the IPO market to center stage because of one very well-known company expected to become public this year. That company is Facebook.

Facebook is more than the place you go to meet up with old friends; it’s a $25 billion company, twice as large as the much hyped IPO of 2011, Groupon. Wall Street investors are anxiously awaiting the emergence of Facebook in to the investing markets but when the hype gets even stronger, should you invest in the IPO?

What’s an IPO?

If you’re like most consumers, you’ve probably never heard of an IPO. An IPO or initial public offering is the first batch of company stock offered to public investors. A company may have issued shares to other investors but the IPO places shares in the public markets. The process of becoming a public company is complicated and expensive but here’s how it works. Larger companies pick one or more of the big investment banks to help with the process. These banks advise the company on what they can and can’t say publically during the IPO process as well as prepare all of the legal documents and help with the pricing of the IPO.

Then, a road show takes place. Company executives travel to big cities setting up meetings with large investors in the primary market. The primary market [4] is made up of large institutional investors like investment banks, larger hedge funds, and mutual funds. If the road show goes well, the primary market will purchase all of the shares and offer them to some of their clients, which could be you. Very popular IPOs will leave very few shares left for retail investors to purchase. For companies like Facebook, it’s unlikely that you will be able to purchase shares at the IPO price before they trade publically.

Individuals like you and I, as well as the smaller institutional investors make up the secondary market. The secondary market [5] is the market most investors understand as Wall Street. Some of the shares purchased in the primary market will enter the secondary market on the day of IPO where trading will begin.

Should I Buy?

Your broker may have purchased shares in the primary market making it possible for you to purchase shares at the IPO price but be careful. First, picking a stock with years of market data to examine is hard enough. An IPO has very little public information to examine. Second, IPOs only come to market when there is an appetite for stocks. The IPO date is timed to capture the highest price possible making it very likely that you’ll be forced to overpay.

Finally, a significant piece of the IPO market are stock flippers who will sell their shares within the first few days of the stock going public making the share price high on the first day but potentially much lower after that. In 2011, the average IPO was down 10.3%, according to Thestreet.com [3].

What’s Hot in 2012?

The hottest IPO of 2012 will be Facebook but others companies are set to go public this year. Electric car maker, Fisker Automotive, Groupon rival LivingSocial, cloud computing giant Dropbox, and real estate search site Trulia are a few of the others we may see in 2012.

Bottom Line

Think of an IPO like the newest piece of technology to hit the market. If you don’t mind paying a premium to be one of the first to own it, buying in to an IPO might be right for you. If you’re the type that would rather let other people pay the big money while you wait for all of the bugs to be worked out so you can buy at a lower price, stay away from IPOs. There will be plenty of time to purchase shares later