Why IPOs Are Unfair To Retail Investors

Retail investors only receive marginal returns from an IPO compared to other types of investors. To say it’s unfair is an understatement.

 

When companies pursue an IPO to gain access to capital from the public, this excites investors. It’s their first chance to get in on the ground floor with a company poised for growth.

 

But the problem is that the company is already on the fourth floor, and retail investors don’t realize they missed the elevator while patiently waiting in the lobby.

 

The ugly truth is that curious investors don’t get their fair share of value from an investment when a company goes public. The system favors the elite investment banks and accredited investors — not the everyday retail investor.

 

We believe everyone should have an equal opportunity to invest. To clear the air, we’ll explain how IPOs are unfair to the average investor despite the idea that they are “public.”

IPOs have private funding rounds

Though an IPO is supposed to be a public offering, it’s actually more nuanced than that. A number of private funding rounds occur ahead of time with investment banks, accredited investors, angel investors, and VCs — all before the company goes live on the stock exchange. These groups purchase stock at lower prices than what the stock is listed for on IPO day.

 

With early buying opportunities, these investors set themselves up for huge profits on day one of the IPO. A majority of that money comes from regular retail investors who purchase stock at an inflated price.

 

There’s still a chance that the retail investor’s initial investment gains value over time. But it will happen a very humble pace — an average of 9 percent annually across all US equities. This number would be much higher if the investor could buy in earlier in the process, but the deck is stacked against them.

 

Consider Benchmark Capital’s early investment in Uber. They invested $12 million years ago in early funding rounds, and that stake is now worth $7 billion at Uber’s current valuation. Early access granted huge returns to these pre-IPO investors.

IPOs favor everyone except the curious investor

You should have every right to invest in a new company if you want to. That’s the goal of financial inclusion: tear down the walls to let anyone invest, regardless of location. Unfortunately for the retail investor, IPOs don’t make it that simple.

 

Here’s who actually benefits from IPOs these days:

 

Underwriters

Every company that wants to go public must hire an investment bank, like Goldman Sachs or JPMorgan Chase. These investment banks have a team of underwriters who survey the market and set the initial price per share. These underwriters typically charge a fee of 5 to 7 percent of the gross IPO proceeds.

 

Angel investors and VCs

Angel investors usually take more risk and bring lots of experience and flexibility to the table. VCs have deeper pockets, but they’ll want a hand in the company in return for their excess capital. Both types of these investors get access to private funding rounds — and will get shares of stock at lower prices. But they’re costly because they’ll want a stake in the company, and maybe even a seat at your Board of Directors table, for their investment.  

 

Accredited investors

These people get access to private funding rounds simply because they are deemed worthy. In the United States, the SEC defines an accredited investor as anyone who’s income that exceeded $200,000 alone (or $300,000 together with a spouse) for two years, and expects the same earnings for the current year. They can also be people with a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

 

Company founders

Company founders have a certain percentage of stock before the IPO, plus they’ve invested their time, their money, and other people’s money in the business. When retail investor demand drives up the share price, these founders make huge returns.

 

The company itself

IPOs raise capital for the company, so they’ll profit when demand for the stock goes up. The company’s prospectus will describe how the funds will be used, and can go toward paying off debts, supporting business infrastructure, or expanding R&D.

 

Then there’s the curious investor, who only wants to get involved in the stock market and build a portfolio of companies. But they don’t get access to the same true value, because the other players on the field have already squeezed most of it out. They’re left believing that an IPO is the only thing available to them and the only value they can get.

IPOs aren’t the most reliable way to participate in entrepreneurial value

Curious investors are seeking out new ways to invest because of value’s uneven distribution in the current IPO model. Traditional investments include commodities and real estate, but these are passive bets. Many investors are looking for better, more secure ways to make money.

 

In the next chapter, we’ll discuss some alternatives to IPOs, along with their pros and cons for the curious investor.

 

Chapter 5: 4 Viable Alternatives To The IPO