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Peek at the Ground Floor Before Leaping

Physician's Money Digest, July 2005, Volume 12, Issue 10

Initial public offerings, more commonly referredto as IPOs, are stock offerings in companies thatare seeking to go public. Whether the IPO is in acompany that is well established or one that isstill in the early stages of development, IPOs are analogousto the lottery. In other words, there are usuallya few big winners and a lot of losers.

Good, Bad, and Ugly

Consider the story of Cisco Systems, which manufacturesswitches and routers for the Internet. Hadyou invested $1000 in early 1990 when the companywent public, your investment would have been worthalmost $1 million at the beginning of 2000—justbefore the tech bubble burst. This equates to an averageannualized return of nearly 100%, or a doublingof your money every year for 10 years. You won thelottery had you invested in Cisco when it initiallywent public and liquidated your holdings at its high.

On the flip side of the coin, there's GlobalCrossing, a telecommunications company that wentpublic in the summer of 1998 at a price of $9.50 ashare. The company's stock proceeded to rise to over$64 per share over the next several months. At itspeak in early 2000, the company's stock was valued atover $47 billion. However, the stockholders of GlobalCrossing saw their entire investment in the telecommunicationscompany all but disappear by the time itfiled for bankruptcy back in January 2002.

Had you regularly invested in IPOs, you wouldhave significantly underperformed investments incompanies whose stocks were already publicly traded.So if IPOs consistently underperform and stocks inalready established public companies outperformIPOs over time, the question is, why do these companiesget created in the first place?

Who wins? Firms that go public are extremelyprofitable to investment banking houses, venture capitalfirms, entrepreneurs, and company insiders. Theinvesting public who buy new stock in these firms arethe losers. They're the ones who think they're gettingin on the ground floor of a great opportunity wheninstead they're getting duped. These investors are leftholding the stock after the venture capitalists, companyinsiders, and entrepreneurs have liquidated theirpositions and reaped a very handsome profit.

Just the Facts

Before you get down on venture capitalists, beaware that they do fill a valuable niche: They bringmany successful firms public. For instance, LotusDevelopment, Teledyne, America Online, and Genentechwere all financed by venture capital firms.

Let's not forget about the investment bankingfirms, which charge an underwriting commission totake these companies public. The underwriting commissionis usually based on a percentage of the valueof the IPO it's bringing to the market. In addition tothe commissions generated in the transaction, thebankers also receive another perk. They're able toallocate the stock to their best customers, who arethen able to purchase shares at the offering price,which is usually far below the price at which theshares begin trading.

This run-up in price represents pure profit towhomever the shares are allocated. For example,when Netscape—one of the largest Internet portals—went public, 5 million shares were sold through alarge investment banking firm for $28 a share. Theowners of those shares were surely ecstatic when thestock opened on the first day of trading at $71.

If, by chance, you happen to be fortunate enoughto obtain a hot IPO at its offering price, it's probablybest to sell it soon after it begins trading, reap theprofits, and move on. Leave funding innovations toothers. You don't want to become one of those overanxiousinvestors who thinks they're going to quadrupletheir money overnight. It could happen, butchances are, for that one big winner there are going tobe many more losers.

and his partner, Harris L.

Kerker, are principals of the Asset Planning Group

in Miami, Fla, specializing in investment, retirement,

and estate planning. Mr. Kosky teaches corporate

finance in the Saturday Executive and

Health Care Executive MBA Programs at the

University of Miami. He welcomes questions or

comments at 800-953-5508, or visit www.assetplanning.net.

Thomas R. Kosky