What are the risks of investing in IPOs

5 mins read
by Angel One
IPOs may seem like an attractive investment, however, there are lots of risks involved with investing in one. If you’re thinking about an upcoming IPO, here’s what you need to know before you buy.

IPOs or Initial Public Offerings is one of the most popular investment modes for all kinds of investors – beginners as well as experienced traders. Owing to the advancement of technology and the introduction of digital platforms, investing in IPOs has become extremely convenient and simple. This has in turn led to a massive increase in the subscriptions seen by new IPOs. While investing in IPOs offers investors numerous advantages, sensible investors should also be aware of the risks involved when choosing this investment mode. 

What is an IPO?

When a private company makes its debut on the stock exchange by issuing its shares to the general public, it is referred to as an Initial public offering (IPO). Simply put, an IPO is a process by which a privately-owned company is transformed into a public company whose shares are listed on the exchange.

Most companies opt for an IPO to bring in liquidity and raise funds. This capital infusion can then be used for various requirements including expanding and scaling a business, optimising operations, improving infrastructure, paying off debts, etc. 

Risks of investing in an IPO

Let’s take a look at some of the main risks of investing in an IPO. 

  • Over-Valuation Issues

Valuation refers to the fixing of a fair price of the shares of the company for the IPO. Factors influencing valuation include demand for shares, growth prospects, industry trends, etc. When an IPO is undervalued, investors get a chance to book profits when markets correct and the stock price climbs to the appropriate level. 

However, due to the increase in popularity of IPOs, there is a high probability that the offer would be over-valued. Due to this, investors may incur losses when the market is correct and the stock price drops to the correct level. 

  • No assurance of allotment of shares

Even if you apply for an IPO, there is no guarantee that you will be allotted shares. This happens in the case of oversubscription of an offer. Over-subscription is when the demand for a new public issue of shares is greater than the number of total shares offered. Due to this, the company cannot allot shares to each applicant. In such a case, a computerized lottery is held, leaving the allotment to a chance of luck. Due to this, even if you have a successful application, you might not get the allotment of IPO shares.

  • High Volatility

As these are newly listed companies, IPOs may witness high volatility in their initial trading days. This happens due to fluctuating investor sentiment. Especially on the listing day, the price of the stock may display sharp movements. In case the share price falls significantly, investors may incur huge listing losses. There is an added risk that due to the heightened volatility, regulators may freeze trading in the particular stock at any sudden moment.

  • Insufficient information about the company

Even though IPOs are usually well-promoted, investors may find it difficult to find adequate information on the company, especially if it has been in operation for just a few years. Investors may have to struggle with evaluating the company’s shares in the absence of sufficient historical data.

Points to remember before investing in IPO

  • Read the Red Herring Prospectus:

    The Draft Red Herring Prospectus is filed by a company when it intends to raise public money. It helps in understanding how the company intends to use the money that will be raised, and the possible risks for investors.

  • Don’t get entrapped by market hype:

     Do not invest in an IPO based on advertisements and promotions. Be cautious of any promises of unrealistic gains and windfall profits projected by the media.

  • Assess your financial goals:

    Review your investment objective and make an informed decision based on your risk appetite.

  • Do not borrow to invest:

    It is not advisable to invest in an IPO using borrowed funds. In case of losses, the financial damage would only get amplified in case one has taken a loan to invest in the IPO. 

  • Price Band:

    The price range jointly set by the issuer company and underwriter within which an investor can bid for IPO is called Price Band. A floor price is the minimum price and the ceiling price is the maximum price at which you can bid for an IPO.

  • Lot size:

    The predetermined number of shares that must be applied to buy an IPO. It is the minimum number of shares an investor can bid in an IPO.

  • Over-subscription:

    When the number of shares applied for exceeds the shares offered in an IPO, then the IPO is said to be oversubscribed.

  • Minimum Subscription:

    The minimum percentage of shares the company needs to raise from the public out of the total issue by the date of IPO closure. The minimum subscription is 90% (dated 27-Oct-2021). If the minimum subscription is not reached, IPO may get canceled.

Final Words: Is investing in an IPO worth the risk?

Investing in an IPO is risky, but it can be a great way to make money. If a company is growing quickly and has a great product that solves a problem, it may be a good investment. However, if it has not solved its problems and addressed its risks, it will likely not be successful. If you want to invest in an IPO, it’s important to do your research and understand the risks involved with each company. There are no guarantees, but if you find a strong company that can solve a big problem, an IPO may be worth the risk.