Any company with shares trading on the stock market is considered a public company because anyone can acquire an ownership stake in it. However, companies don't start this way, and it typically takes years to reach the point of wanting (or being able) to go public.
When companies decide to go public, they typically do so through an initial public offering (IPO). IPOs can be exciting opportunities for investors because many see them as a way to "get in early" on a stock, but they also come with inherent risks that require a bit more due diligence.
Every investor approaches IPOs differently, but here are three steps I take to prepare for any investment in a company that will soon go public.
1. Read the company's prospectus
The prospectus is the financial filing investors should seek out for any IPO. It provides extensive information about the company, including its business model, financial health, industry analysis, risk factors, and management team.
This is all information the company didn't have to previously disclose as a private entity, but the IPO process requires it so investors can have insight into what they're potentially buying.
The first thing I look for in a company's prospectus is its core financial information. This includes the balance sheet, income statement, and cash flow statement, which combine to provide a comprehensive view of the company's financial standing.
Pay special attention to the risk factors as well. Though the list will include low probability concerns and generic challenges any business might face, it can still provide investors with insights into a company's competition within the industry, roadblocks to its growth, and other important details.
2. Search around for third-party information about the company or industry
Though the SEC has requirements regarding what an IPO candidate discloses in its prospectus, the company itself still puts that document together with its accountants and investment bankers. With that in mind, it's important to supplement your due diligence with information from third-party and external sources.
News and media coverage can give a different perspective, for example. Industry reports provide investors with more insight into broader market or industry dynamics. Independent analyst reports can help you compare similar companies. Even social media can have something to offer with information not typically found in those other mediums.
No single source of information is the end-all-be-all, and taking from different places can provide you with a more holistic view of the business.
3. Decide if you want to wait until the lock-up period is over
Whenever a company goes public, a lock-up period prohibits company insiders -- typically management, early investors, board members, and employees with equity -- from selling any shares for a predetermined period. The length of this lock-up period varies, but it's typically between 90 and 180 days.
The reason behind this lock-up period is to avoid a situation where a flood of insider selling results in extreme volatility in the first weeks following an IPO.
The end of the lock-up period can also signal how insiders view the company and its prospects -- low selling, for example, might mean insiders are bullish on the stock (and vice versa). To learn about insider trades, look at the company's SEC Form 4 filings, which insiders must fill out when they make a transaction. Some online trackers aggregate this information for you.
Just keep in mind there are many variables that influence what people do with their assets, so any insider selling (or buying) should be treated as a single data point.
You can rarely have too much information about a company
IPOs often come with significant hype, and it's these situations where you want to be certain any investment decision you make is based on thorough research and analysis.
