IPOs can be exciting but before you jump in – make sure you understand the risks.

An initial public offering (IPO) is essentially the birth of a company in its public form. It changes many things about the way that management runs the firm and can present opportunities and dangers for retail investors. IPOs are more common during bull markets and the recent rally in stocks may provide another fertile environment for these corporate events.

VIDEO: The Risks and “Benefits” of an IPO

If a private company needs capital that beyond its own ability to self-finance through operating cash flow there are a few alternatives management and the firm’s ownership can utilize to provide that capital.

These may include debt, private investment or a public investment through an IPO. Each of these alternatives is evaluated based on current and projected needs for cash.

In an IPO a company’s owners sell a portion of the firm to public investors. This is usually done through an underwriting process that looks and acts a bit like a pyramid.

The company negotiates a sale of its stock to one or more investment banks that act as an underwriter for the offering. The small number of underwriters each sell their stock to the much larger pool of investors in the public markets.

Underwriters are compensated through fees and underpricing in the stock they are purchasing from the firm. An underwriter takes a risk that they will be able to sell the stock they bought from the firm (that was under-priced) for more than they paid.

The underwriter provides value to the firm by making a large purchase and facilitating an orderly sale of their initial stock. In some cases, the underwriters may initiate analyst coverage for the firm following an initial quiet period after the IPO.

Other institutional and retail investors can purchase the stock in the public market but it is not uncommon for an anticipated IPO to lead to a fast run-up in the stock’s price. As the underwriters “flip” their stock into the market, selling pressure can push prices back down and a lot of volatility is common.

There is some statistical evidence to suggest that investing in new IPO’s can outperform a generic stock index. However, the assumptions behind that evidence indicate that it may not be possible for a retail investor to build a diversified portfolio of recent IPOs.

Historical performance and financial data is not as available for a stock issuing its IPO as it is for a company that has been publicly available for a long time. This increases the number of “unknowns” about the firm and can make these investments very risky.

However there is some information available about the firm through the public filings made before the offering. It makes sense for a potential investor to look for the same kinds of fundamental factors that they would in an existing public firm.

Despite the risks, it is likely that IPOs will continue to attract investors because they are usually issued by companies in a transitional phase. Companies in transitions are exciting and interesting to investors. The prospects for a big win and the possibility of becoming another “IPO-millionaire” can be very enticing. Just make sure you understand the risks before you take a chance.

Note: This is a summary of the IPO process. As you can imagine, the actual procedures are much more complicated. You should also know that although the process outlined in the article is the most common method for an IPO there are other formats. An auction format or hybrid auction is rare but also sometimes used to try to make the process a little more equitable.