One of the most common questions we get when a company holds its Initial Public Offering (IPO) is why you can’t access it as soon as the market opens.
It’s a fair one too. IPOs often see a pop in price on the day they launch and investors naturally want to take advantage of that.
Unfortunately this is rarely possible. And to understand why that’s the case, you need to know a bit about how an IPO actually works.
Bring in the underwriters
An IPO doesn’t just involve a company taking a bunch of its shares and dumping them on to a stock exchange.
Instead, a firm will make an underwriting agreement with an investment bank, like Goldman Sachs or JP Morgan.
The investment banks have several roles here but the important ones for our purposes are...
- Figuring out what price the firm’s shares should be sold for
- Finding investors willing to buy those shares
- Agreeing to buy up any shares that remain if it fails to find enough investors
When we’re talking about ‘investors’ in this context, we do not mean regular people like you and me. IPO investors tend to be major financial institutions or extremely wealthy individuals.
The reason for this is that they are the only ones able to commit to buying up large chunks of the shares on offer, something that requires vast sums of cash.
Going to market
The other thing to realise is that when these investors buy shares, they are not doing so on a stock exchange.
The IPO takes place between the company and the investors, with the underwriting investment bank acting like a middleman.
In short, the ‘real’ IPO process is when these investors buy the shares they agreed to purchase from the company.
This generally takes place on the IPO launch day before the stock market opens, with the underwriter allocating shares to investors based on how much they’ve agreed to buy.
Once this process is complete, the investors are free to start selling off their holdings on a stock exchange.
Learn more: Upcoming IPOs in 2021
Forming a price
This brings us to the annoying situation in which you can’t buy IPO shares as soon as the market opens.
What happens is that the IPO investors begin selling off some of the shares they’ve bought. At the same time, lots of smaller investors will place orders to buy them.
Sitting between them is a designated market maker — a company that has been chosen to be the primary buyer and seller of shares in that firm — that will log both buy and sell orders.
By analysing those orders, the market maker can get a sense of how much demand there is to buy a particular stock versus how much is available to sell.
Their goal in doing this is to try and figure out what the optimal price is that will allow for the maximum volume of buying and selling in the stock when it begins trading.
And this price formation process can take some time. When Airbnb went public it took until just after 13:30 New York time for the stock to start trading on the NASDAQ, even though the exchange usually opens at 09:30.
What this reflects is the pushes and pulls of demand.
The big institutions are likely to have certain amounts of stock that they’re willing to sell at a given price. If the price rises above that point, they might consider selling more or, if the opposite is true, less.
Naturally, the time that all of this takes filters down to regular investors like you and me, who are left pushing ‘buy’ over and over again on the company’s stock screen and wondering why nothing is happening.
Sadly there isn’t likely to be a solution to this problem any time soon. It’s true that alternative listing methods, such as special-purpose acquisition companies (SPAC), don’t require the same pricing process.
But most big-name firms are not going to use them to list on an exchange. And given that it’s those big names most people are interested in, investors are going to have to deal with the price formation time lag for the foreseeable future.
Learn more: SPACs vs IPOs
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