Initial public offerings, or IPOs, are some of the hottest stocks in the market. They’re popular with investors because of their reputation for a huge “first-day pop” — averaging 12% to 17% over the last few years — and the potential for investors to get in early on a long-run success story.

Here’s how an IPO works, how to invest in one and some tips on how to avoid getting burned.

IPOs explained

As the name suggests, an initial public offering is a company’s first sale of stock to the broader investing public. Before going public, the company is private and has relatively few investors. But once it goes public, any investor with enough money to buy a share can become a part owner of the business by purchasing it on a stock exchange.

Why would a company go public?

Companies go public for a variety of reasons, but some of the most important include the following:

• To raise money to expand quickly
• To gain an advantage on less well-funded rivals
• Greater financial stability, lowering the cost of funding the business
• The ability to raise more money if needed
• A way for early investors to cash out or diversify their investment

A company might go public for one or many of these reasons — or for some other reason entirely. It depends on the specific situation of the company and its investors.

How IPOs are priced

The price of the new stock is first determined by the investment bank or banks underwriting the IPO. Stock analysts examine the company’s business, analyze its competitive position and assess its prospects. Then they’ll assign a valuation to the company using various tools, such as comparing the stock to those already trading in the market.

With a price range for the new stock in hand, they’ll approach potential buyers. If they find enough interest from buyers, the stock will be sold in that range and potentially even higher if demand is enormous. However, if analysts have overvalued the stock, the price range may have to be reduced to entice investors into purchasing enough shares for the IPO to happen.

Facebook (FB) presented one of the most unusual IPOs of the recent past. As one of the most-hyped IPOs of all time, Facebook had investors clamoring for stock. At first, the stock was priced at $28 to $35, but demand was intense enough that the underwriters raised the range to $34 to $38. There was even enough demand that they increased the number of shares offered to the public.

With so much demand, the stock priced at the high end of the range. At $38 a share, the company offered more than 420 million shares to the public in May 2012, making it the largest tech IPO in U.S. history. Everyone felt that Facebook was a sure thing.

Yet from that offering price of $38, the stock moved steadily lower over the next few months. Its first day started off well, with the stock opening at $42 a share and moving as high as $45. But it retreated to close at $38.23 — just above the IPO price. Over the next three months, the stock lost half its value, plunging to just $19. For a hyped IPO, it couldn’t have been a bigger letdown.

But over the months that followed and into 2013, the stock bottomed — and ultimately moved much higher. The stock started 2019 trading just over $130 after being more than $200 in the prior year, as a series of privacy scandals have rocked the company and its stock.

Investing in an IPO

Brokers may allow you to invest in an IPO, but they’ll often have eligibility requirements that you must satisfy. For example, Fidelity Investments requires investors to fulfill one of three criteria: have at least $100,000 to $500,000 (depending on the underwriter) in assets with the broker, have made 36 trades over the last 12 months or be part of the company’s Private Client Group. If you don’t meet the requirements at one broker, hunt around and see if the hurdle is lower at another.

Finding upcoming IPOs

Once you’ve got eligibility, you’ll need to know which IPOs are available. Many financial websites publish calendars that list upcoming IPOs and other vital statistics about the offering — the price range, deal size, date and ticker symbol.

Here are a few avenues to find this information:

• The Nasdaq and New York Stock Exchange both list upcoming IPOs on their sites.
• Google Alerts can scour the web for upcoming IPOs based on a keyword search.
• Sites like IPO Monitor, Renaissance Capital and IPOScoop offer calendars and relevant details about upcoming offerings.
• The SEC’s EDGAR database will show S-1 filings from upcoming IPOs.
• Your broker may have an IPO alert that will inform you of any new issues.

Getting in on an IPO

So an upcoming IPO looks interesting — how do you get in on the action? Find your broker and see if it’s allowing customers to submit a bid for shares. Then follow the process on the site.

Even if you’re eligible, have the cash and are a good customer with the broker, don’t be surprised if you don’t get to participate in the IPO. It’s a hot market, and there are relatively few shares to go around. The underwriters often reserve these shares for their best clients — big institutional clients that bring them business. Retail investors usually aren’t on their radar.

If you can’t get an allocation in the offering — and very few individuals do — then you can always pick up shares on the exchange, buying the new stock as you would any other after it begins trading. You may want to wait until the fervor dies down, as the stock may fall once the initial hype has worn off. You may even be able to buy the stock for a price that is lower than what IPO investors paid.

How to avoid getting burned on a bad IPO

Investing is always risky, but investing in IPOs can be even riskier. Here are some of the major risks associated with new companies that you’ll want to assess to avoid getting stuck in a bad investment:

• Be wary of an untested business model: The biggest risk with IPOs probably is the fact that they often present an untested business model. How will the company fare in a downturn? How will rivals respond? How does the company respond to challenges?
• Examine the company’s path to profitability: It’s not unusual for a company to debut without being profitable, though it usually must have a plan to become profitable in the near term. So will the company become profitable? How soon?
• Measure the strength of the company’s management: A new IPO often has new managers investors are not familiar with. Is the management team experienced? Does it have the ability to guide a growth company? Is it a good steward of shareholder capital?
• Analyze the limited historical information available carefully: There’s often very little information about the business apart from what’s contained in the IPO prospectus filed with the SEC. So it can be hard to judge how the company will perform over a business cycle.

These are just a few of the more pertinent risks for IPO investors, and those looking to invest in individual stocks will have to consider other risks that are relevant to any company. (If you’re looking to research a company, here’s how to get started and what you need to look for.)

But as with all investing, you’ll want to read the company’s public filings to understand the business better. That’s the best initial source of information if you’re considering buying an IPO. The company will lay out its opportunities and risks and describe the business in some detail. If it’s a hot IPO, the prospectus also will lay out key details that the financial media may not report, though it can be useful to read media reports to find out what other investors are thinking. A company’s public filings are all freely accessible through the SEC’s EDGAR database.

Focus on the long term

If you can’t get in on an IPO, don’t despair. Investing is about the long term, not what happens on the first day of trading. If a company presents a really good opportunity, its stock is going to rise over time, and that means you have the time to thoroughly examine the opportunity first. If the stock still looks attractive and poised for success, you can buy.

Remember: IPO investors in Facebook were excited about the stock, it was poised for success, and it still got hammered by 50% in the next three months. Investing is a marathon, not a sprint.

Bottom line

It’s tough to be part of the select crowd that can buy stocks before they IPO, but this kind of investing carries many of the same risks that all investing does — plus a few others. It takes a lot of work to buy individual stocks, as investors must spend time analyzing the company, its earnings reports and the industry. For investors who don’t have the time or desire, one great alternative is to invest in index funds. (Here’s how to invest in index funds and what you need to know.)