What Is a Hot IPO?
The first time a company issues shares to the general public through a stock exchange is known as an initial public offering (IPO). One or many investment banks can act as underwriters for such an offering. The objective of an IPO is to raise capital for the issuing company’s growth, while also offering an exit route for existing shareholders.
An initial public offering with significant demand is known as a hot IPO. These IPOs are popular even before meeting the market, generating immense interest from investors and media. This surrounding hype and attention generally impact the stock price positively, once the company goes public. Hot IPOs can be tricky to invest in, particularly for those companies that do not have a proven success record.
How hot IPOs work
When a company is first formed, it is owned by a single person or a distinct group of people. One way for private companies to raise money is to ‘go public’ through an IPO. They can raise a fair amount of money in a short time, especially if the issue gets public attention and becomes a hot IPO. IPOs allow private companies to harness the public demand for their stock. The proceeds may be used to repay debt, finance expansion, or invest money for future growth.
The first step is to find at least one investment bank to analyze the prospects for a successful IPO of the company's stock, of which, one or more investment banks will act as underwriters for the proposed issue. The underwriter helps the company set the price per share. They even acquire some shares to offer to either institutional investors or individual investors, at their discretion. Another term one comes across is ‘underwriting spread’. This is nothing but a commission or a fee on the proceeds of the sale that the bank charges.
Increased demand for stock during a hot IPO, often results in a sharp rise in stock prices, soon after it begins trading. This steep price rise is generally considered unsustainable, with an impending price decline that can have a significant impact on the market itself.
Sharp price moves can affect initial shareholders after trading opens on the secondary market. Underwriters may give preferential treatment to high-value clients when offering shares in a hot IPO, so they bear some risk if they overprice the stock.
Rapid price fluctuations after a trade opens can impact early shareholders in the secondary market. Underwriters may distribute risk, by giving preference to high-value clients when offering shares in a hot IPO.
Example of a hot IPO
Facebook’s (now, Meta) initial public offering is a classic example of a hot IPO. The issue sought to raise about $10.6 billion by selling more than 337 million shares at $28 to $35 per share. Analysts predicted an oversubscribed IPO.
When the market opened on May 18, 2012, investor interest showed that demand for company stock was higher than supply. To meet investor demand and make the most of the oversubscribed issue, Facebook increased the number of shares to 421 million. Additionally, it also raised the price range from $34 to $38 per share.
Facebook increased both — stock supply and price — to meet demand and to effectively reduce oversubscription. However, the stocks plummeted in the first four months of the deal. The stock failed to trade above its IPO price until July 31, 2013.
Reasons for launching hot IPOs
Companies issue an IPO to raise equity capital in a short period, allowing early investors to cash out. Most of the money raised for that stock allows companies to fund their business’s growth and cover their existing obligations.
The process of setting up an IPO comes with tremendous regulatory compliance. All information is disclosed to potential investors through a prospectus. Many IPO issuing companies are in a nascent stage — small, and probably risky — but generate strong interest because of their market position. Internally generated funds are deemed inadequate to enable growth, and therefore an infusion of cash from an external source becomes the only viable option.
Oversubscribed and hot IPOs: Other considerations
Hot IPOs appeal to investors who expect their stock demand to exceed the number of shares offered. IPOs with higher demand than supply are considered oversubscribed. This makes them an easy target for short-term speculators.
Since hot IPOs are likely to be oversubscribed, companies often allow underwriters to increase the size of the offering to accommodate more investors.
To achieve substantial interest in the offering, underwriters must balance the size of the IPO with an appropriate price. This balancing act maximizes profitability for the company and its underwriter banks.
When a hot IPO is an underpriced issue, prices usually rise rapidly after stocks enter the market and adapt to the high demand. An IPO overvaluation can cause stock prices to fall rapidly, even though higher stock prices benefit the underwriters that issue the stock.
An IPO is one way of going public amongst others, including a direct listing or a direct public offering. With great interest from the media and investors, hot IPOs remain the type of offering that garners the fastest results.