IPOs often generate excitement from the investment community because they imply new opportunities for earning income. Sometimes IPOs are for new companies with limited history, and sometimes they are issued for companies that have been around for decades that are shifting from private to public. While many IPOs reap the benefits of investor interest and media representation, some IPOs don’t quite reach their goals. Here are reasons why some IPOs fail to grow beyond their stock market debut and end up shrinking wealth.
Learning From Past IPOs
Since the financial crash of 2008, many popular tech companies have appeared on the stock market, but they do not always perform the way investors want. Facebook got off to a rocky start after its IPO in May 2012, eight years after it was founded. Its IPO price was $38 per share and rose to $45 on the first day of trading but closed near the opening price. The stock price then sank as low as under $27 within a week, and by September, it bottomed out under $18.
Investors argued that Facebook had been overvalued, and lawsuits accumulated as its lead underwriters began to lower earnings forecasts. Morgan Stanley paid a settlement later in the year after being accused of influencing analysts. Initially, the Facebook IPO was considered a failure, but eventually, everything worked out for patient long-term investors as the stock had grown five times its IPO value by late 2019.
The main problem with the Facebook IPO was that its underwriters did not have enough information to accurately assess the company’s actual financial performance or prospects. Leading up to the IPO, private equity investors and venture capitalists had tapped into the company’s high growth phase, followed by IPO investors initially sitting through a big sell-off.
Venture Capital vs IPOs
One of the subtle lessons from Facebook is that investors need to know how valuations have evolved when leading up to an IPO. LinkedIn, for example, grew seven times in value prior to its IPO, only to be followed by slower growth. The simple explanation is that venture capitalists and private equity investors beat retail investors to the jackpot before the public offering.
Overvaluation, Debt and Economic Fears
When a company is saddled with too much debt and doesn’t announce any clear paths toward profitability, IPOs have a higher likelihood of failure. Many private companies go public to raise funds, and it may take years for these firms to realize profits.
Sometimes valuations rise too quickly due to investor excitement and eventually the price comes back down. In 2019, nearly half of companies with IPOs fell lower in price by the end of the year, such as for Uber and Lyft. Several unicorns (startups valued at over $1 billion) cancelled their IPOs in 2019.
One of the reasons 2019 turned out to be a dismal year for IPOs is reflective of a Preqin study that found 74 percent of investors believed the market was at its peak and would be followed by declines due to recession fears.
When investing in an IPO, investors need to find out if late-stage venture capitalists and private investors have cashed out yet on big earnings. It’s also essential to be aware of profit margins and analyst projections for earnings. The overall economic landscape also plays an important role in IPOs.