IPO Investing: How to Get In On the Ground Floor of Newly Public Companies

2020 has been an incredibly active year for IPOs. In the past few months alone, we've seen highly anticipated IPOs such as Snowflake (NYSE: SNOW), Rocket Companies (NYSE: RKT), and Palantir Technologies (NYSE: PLTR), plus dozens more.

However, actually investing in IPOs can be confusing, especially for newer investors. If a company that you want to invest in plans to go public, here's what you need to know.

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What kind of IPO is it?

The most important thing to know when a company you want to invest in goes public is what type of public offering it is.

Until a few years ago, virtually every company went public in the same basic way. They would file an initial registration statement with the Securities and Exchange Commission and hire one or more investment banks to underwrite an initial public offering, or IPO. The company would decide how many new shares to sell and price the IPO. Interested investors would commit a certain amount of capital and receive shares, and the stock would then begin trading on the public markets.

While this is still how the majority of companies go public, it isn't the only way. There are three types of public offerings you might encounter, and the methods for investing in each type are very different.

Traditional IPOs

This is the process described in the last section. Unless your broker is an IPO participant, you might be out of luck as far as buying shares at the IPO price. As an example, my brokerage account is with TD Ameritrade. There have only been a handful of IPOs available through that platform in recent months, and none of the major IPOs was among them. Even if your broker does participate, they might restrict IPO investing to certain customers, such as those with account balances over a certain threshold.

Many investors maintain brokerage accounts with two or more firms to give themselves access to more IPOs. Still, unless your broker gives you access, you'll have to wait until the stock starts trading on the public markets, which typically doesn't happen until a few hours into IPO day. If you're curious about whether your brokerage might offer a specific IPO, call them or check the IPO calendar on the trading platform.

Direct listings

This method has become quite popular in recent years and is how Palantir went public recently. Slack Technologies (NYSE: WORK) and Spotify (NYSE: SPOT) are other notable examples of companies that went public through direct listings. In a direct listing, new shares are not created and sold to investors, as in a traditional IPO. Instead, the company's existing shares are directly listed on a major exchange and are simply traded based on supply and demand right away.

To buy shares of a company going public through a direct listing, you simply wait until shares start trading on the day of the direct listing.

SPACs: A very 2020 way to go public

A SPAC, or special purpose acquisition company, is the newest way companies are going public. The method has soared in popularity in 2020. The general idea is that a SPAC -- which is also referred to as a blank check company -- will be created to raise money from investors. The SPAC's managers then identify a company to take public, negotiate terms, and then acquire the target company.

Once the acquisition is finalized, the SPAC changes its name to reflect the acquired company. Two notable examples of recent SPAC IPOs are Virgin Galactic Holdings (NYSE: SPCE) and Nikola Corporation (NASDAQ: NKLA). Real estate tech company OpenDoor is planning to go public through a SPAC shortly.

To invest, you can either buy shares of a SPAC before it has found an acquisition target or buy shares after a SPAC has announced a merger agreement.

Should you invest in an IPO?

Before you jump in and buy shares of an IPO, it's important to realize that IPO investing can be volatile and risky. While some IPOs soar after going public, many don't. Before you invest in an IPO, be sure you're prepared to deal with some initial turbulence. You should also read the IPO prospectus (known as the S-1 in SEC terms) so you know exactly what you're getting into.

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Matthew Frankel, CFP owns shares of Slack Technologies. The Motley Fool owns shares of and recommends Slack Technologies, Spotify Technology, and Virgin Galactic Holdings Inc. The Motley Fool recommends Snowflake Inc. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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