Tip of the Week: Beware the IPO Myth

Myth: Strong market support for a stock always follows a traditional IPO.

You have probably heard this line a million times; however, nothing can be further from the truth.

The basics of an IPO work like this. A company hires an investment banking firm to serve as lead underwriter of the stock offering. A prospectus is put together to be approved by the SEC and FINRA. Next, the underwriter enlists the help of other brokerage firms, each receiving a commission upon the sale of stock to its customer. The underwriters technically purchase the shares from the company at a discounted price and then resell the shares to its customers, pocketing the difference.

What you may not have heard is that brokerage firms are encouraged to continue participation in the aftermarket if they want to be included in the initial sale and receive commissions. This ensures that people buy and sell the stock for sometime while the initial group of buyers can get out of the stock and make a swift profit. Without this aftermarket support, the stock crumbles, which can happen more often that you think in IPO stocks.

Sometimes the newly public company may be strong, gaining legitimate support; however, this manufactured support drives the stock in its early stages. There is no guarantee that this support will continue on after a few months, if at all.

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