Tips for Investing in IPOs

Ah, the IPO.

The Initial Public Offering of a company, or IPO, has become one of the hottest buzzwords in the investing world—much of it thanks to Facebook's major IPO release. As popular as it may be to talk turkey about investing in a brand new stock, the practice itself is quite old and quite risky.

Every year since the stock market's invention, there have been companies offering up an IPO. IPOs are when a company first become publicly traded, and often mean that the price of a company's stock will be sold at a discounted rate to those who are early adapters.

It sounds great on paper, but there's a reason why IPOs are some of the most dangerous investments you can make. Many IPOs do not last for more than a year, and it's not unheard of to lose everything you invested in an IPO.

Want to avoid losing your shirt? These tips for investing in IPOs for beginners will help you out.

This is one of the tips for investing in IPOs that seems obvious, but isn't. Part of the reason why IPOs get so much hype is because there's a certain level of exclusivity to them. To get access to an IPO, you have to be with a brokerage that will offer that access.

You're not going to be able to access an IPO from a micro-investing app like Robinhood. You'll need to open an account with a major brokerage firm like TD Ameritrade.

Those aren't all the things to know before investing in IPO stocks, though.

An account alone is not enough to get you access. You have to prove to be eligible (read: responsible and rich) enough to access it. TD, for example, will only work with people who have at least $250,000 in their brokerage or have traded at least 30 stocks in the past year. Each brokerage has different standards, so find one that will accept you.

Don't expect to find objective information on the IPO of your choice.

One of the best tips for investing in IPOs is to try to throw out all that you know about due diligence in the traditional sense of the word. Realistically, you won't be able to find much objective information on any IPO.

IPOs are not held to the same standards as major corporations. If you're looking for hard numbers, you will need to accept it won't be likely to find. Worried? You probably should be.

Though objective information isn't possible, you still should read the prospectus and get an idea of how the IPO will be used.

No one just throws their hands up in the air and decides that they want to get an IPO. There is a reason for the madness, primarily because it's a difficult thing to do.

Most of the time, it's to let management and private investors "buy out" of the company. Sometimes, the money gotten by an IPO will be used as a fundraiser for new technology. Other times, there are other reasons.

As an investor, you have the right to find out how the money you're putting in will be spent. Finding out the nuts and bolts of how the company operates and will continue to operate is the most important aspect of figuring out whether you should invest.

One of the best tips for investing in IPOs is to look before you leap—even if you can't get objective numbers to back it up.

Avoid IPOs that have red flags all over the place.

If you look at a lot of the worst IPOs of all time, the signs that they were going to fail were there. It's just that no one noticed them at the time. Tips for investing in IPOs almost always boil down to looking before you leap and asking yourself if it seems like a normal course of business.

Some of the bigger red flags to watch for include:

• Finding out that the money is going to repay loans or buy equity from the founders. This suggests that the company cannot pay its own debts, which in turn, tends to be a pretty ugly sign. You might want to skip this one.
• Realizing that their business model is too pricey to function. This is what did Pets.com in; the cost to ship pet food was just too much at the time. If the business model doesn't make sense now, it won't make sense after the IPO either.
• A prospectus that's very vague. Remember—IPOs do not have as many regulations as other investments. This could be a sign you're dealing with a shady business that's just trying to skate through with minimal documentation.
• Being backed by a shady brokerage. Not all brokerages are alike when it comes to backing an IPO. Reputation matters. If it's a low-rep brokerage, you might want to pass on principal alone.

The stockbroker is not your friend.

Perhaps one of the most biting tips for investing in IPOs is a gentle smack in the head when it comes to actually talking to brokers. Brokerages are there to make money, and at times, they aren't always legally bound to serve your best interest.

A brokerage makes money from sales and ensuring the IPO has a bunch of investors. In most cases, an IPO that's expected to do well will barely ever be mentioned by a broker. They have customers waiting to buy those shares; they're selling like hotcakes. They have no need to hawk wares.

On the other hand, a bad IPO will typically need a lot of help to get off the ground. Investopedia warns against buying shares that are being given the "hard sell" from your broker. Chances are, there's something you need to watch out for there.

Look at the company's past performance before you get in on the IPO.

We all have heard the classic phrase, "past performance is no guarantee of future results." It's a financial disclaimer that appears on just about everything involving investments—and it's true. Doing well in the past doesn't guarantee that it'll continue to do well.

While it's not a guarantee, it's still a strong indicator that they will do well in the near-future. What I'm saying is that you should look at an IPO's past to determine whether the future would be something you'd want to try out.

Most people who are in the market would tell you to pull a Warren Buffett and avoid IPOs altogether, but that might not necessarily be wise for you.

Warren Buffett tells people to avoid investing in IPOs, and honestly, he'd be right to say that. The majority of IPOs fail, which is why you might want to avoid them. If you absolutely, positively are sure that an IPO will work well for you, you might want to wait until the lock-up period ends.

The lock-up period is a designated time of three months to three years. This period is a time when employees and equity holders are barred from trading in the IPO stock.

This is one of the tips for investing in IPOs that's meant to minimize risk of loss. If you find that all the people in the company are selling, you might end up dodging a serious bullet. After all, mass sell-offs tend to be one of the largest indicators that a company is going under.

Waiting also allows the stock price to stabilize, which helps you avoid both panic selling and buying it at too high a price.

Be realistic about the IPO in question.

A large part of all the tips for investing in IPOs involves doing your best to look at things objectively. Does the IPO solve a need? Do you have full proof that the IPO will be around in 10 years? Does the IPO seem like it's solving a need no one has in the market?

If the future of the product seems hazy at best, you should not invest. On the other hand, if the product in question is a must-have, you might want to consider it.

Please, please, please don't invest for the wrong reasons.

This is one of the tips for investing in IPOs most people in the industry will never tell you—but they should. The reason you should want an IPO in your portfolio is because you genuinely believe in the company and feel it will do well in the future.

If you're trying to invest in an IPO just to say you're part of the IPO club, you're going to have a bad time. Just because something is exclusive doesn't mean it's a good option for you, especially when it comes to investments.

The reason why IPOs are so limited isn't just because they're new. It's because they are extremely dangerous investments to make, and because it's not wise to let people invest willy-nilly in high-risk options as a brokerage.

Please do not invest in an IPO just to say that you did. You'll look like a fool and be poorer for it.

Finally, don't go "all in" with IPOs.

One of the best tips for investing in IPOs is to avoid just having an entire portfolio of them. In a wisely put-together portfolio, IPOs will be the icing on the cake—not the cake itself. After all, the riskier the investment, the less it should make up your portfolio.

Unless you want to lose money, that is.