The majority of businesses are privately owned; they are not traded on a stock exchange.
Businesses like your barber, local restaurant or coffee shop are examples of business that are probably owner-operated.
But as businesses grow and look to expand, they often fuel their expansion by raising money from outside parties. One way to do this, is to sell ownership in the company.
This is a quick rundown of the lifecycle.
Angels and VC
Companies starting up are effectively funded by their founders.
Though it's common for the first source of capital to be raised from angel investors.
The term 'angel' actually comes from Broadway theater, where it's used to describe a wealthy individual who provides money for productions that would otherwise shutdown.
While angel investors share a common name, they are a little different.
In business, often they are retired entrepreneurs or executives looking to invest in up and coming, fast growth companies. Though they may also invest for more than monetary reward, similar to a Broadway angel.
The amount of money they provide can range between a few hundred to a few million dollars. For example, Facebook’s angel round was $US500,000.
The next round(s) of financing are usually provided by a Venture Capitalist (VC). A VCs primary job is to provide a return to their investors, so unlike angels they are usually investing for purely monetary rewards.
For VCs, the goal is to invest in companies who will eventually have an exit event.
An initial public offering (IPO) is one such event. When a company IPOs it begins selling its shares to the public.
When a company decides to go public, they enlist the help of an investment banking or brokerage firm to help list their company on a stock exchange.
Prior to listing, a company is privately held, even after multiple angel and VC funding rounds. This means there are a small group of people who own the majority of the stock and have a controlling interest in the business.
IPOing is a complex process and not every business will IPO. Usually, to IPO a company must be well established and have a compelling track record.
Prior an IPO, the company stock has never been publicly traded. This often means it’s hard to determine if the stock price will increase or decrease.
While IPO stocks can be volatile, investing in some IPOs can lead to strong growth.
Let’s use Facebook as an example.
Facebook’s IPO was, at the time, the largest tech IPO in history. Even still, it was not well received. Wedbush Securities analyst Michael Pachter called Mark Zuckerberg’s hoodie a “mark of immaturity”.
When Facebook listed on the NASDAQ stock exchange on May 18, 2012, its offering price was $38.00. It was offering a little more than 420 million shares, which meant Facebook was looking to raise about $16 billion from the IPO.
By August 20, 2012 the price had fallen to $20.011. The Wall Street Journal called the IPO a “fiasco”.
Investors who bought in during the IPO had lost nearly 50% of their initial investment in just a few months.
Now a little over 5 years later, Facebook is trading at around $169. That’s about a 4.4x increase in price.
While this is impressive growth over a five year period. It’s important to note that it was not all smooth sailing. IPO stocks can be extremely volatile.
Remember, when you buy shares from an IPO, you are buying directly from the company rather than from other investors. The market hasn’t had the opportunity to determine what it believes the stock price should be.
Contrast this to buying stocks that have been listed for awhile. When you buy directly from other investors and not the business itself. These stocks have had time for investors to decide what they are willing to pay and may be more stable.
Investors call this trading shares on the secondary market. You aren’t buying directly from the company.
In the end, it’s up to you to decide if you would like to invest in IPOs. We just want you to make an informed decision about whether or not you will.