Understanding IPOs and IPO Scams
You don’t have to spend too much time around the stock market to discover that there’s something fishy about many stocks’ initial public offerings, (IPOs). The standing joke is that IPO really stands for “It’s Probably Overpriced”. While that may or may not be true in any given case, there are a large number of pitfalls awaiting the would-be IPO trader or investor. It’s a case of caveat emptor, and in order to be suitably wary you need to understand how an IPO works and how it can be manipulated to your disadvantage.
An IPO is the means by which a private company is sold to the public. The owners of the company will approach a major investment bank (sometimes referred to as a “bulge bracket” bank) to underwrite the IPO. That bank will then create a syndicate of banks and brokerages to run the IPO. Stock shares are then sold by the company to the syndicate and by the syndicate to the syndicate members’ customers. The deal can be structured a couple of different ways, but in general the syndicate guarantees they will find buyers for the shares, accepting financial risk if they fail. The syndicate sells the shares of the soon-to-be public company at a higher price then they acquired them. This gap is set as part of the underwriting contract, and has historically been about 7%. Once the shares have been “allocated” to the syndicate’s customers, the stock can begin trading on an exchange. The bulge bracket bank which lead the IPO typically acts as the primary market maker or specialist for the new stock.
There is nothing inherently wrong with this setup. Yes, the syndicate and the bulge bracket bank anchoring it is taking a big cut. But they’re also providing an army of salesmen to place the IPO with prospective customers. Without those salesmen to drive demand, the shares might not be sold at all or might sell for a much