Why IPO is a really bad time to invest in a company?

When I first used Amplitude back in 2017, I fell in love with the product. Amplitude is an analytics tool that product and engineering teams in modern technology companies use to derive insights from vast user data. These tools are an absolute necessity for building and scaling digital products. I am a fan of Amplitude and I believed in its potential, so it was only natural that I rooted for the company when it went for its IPO in Sep 2021.

But buying the company’s stock on the IPO day would have been a mistake. It’s stock price has fallen by more than 72% in less than 12 months. I am not arriving at this conclusion by looking at just this one example. Instead, I think that as a principle it’s never a good idea to invest in a business at its IPO, how much ever one likes the company or is optimistic about its future.

Amplitude is not alone. 2021 was the year of some amazing tech companies going public. One could sense that the valuations seemed a little high, but there was optimism and confidence in the air about the potential of these innovative businesses. In the US, beloved consumer tech companies like Doordash, Affirm, Allbirds, Duolingo, Robinhood and sturdy SaaS companies like Snowflake, Braze, Squarespace and UI Path were among many others that opened its doors to retail investors.

However, just like Amplitude’s stock price, the stock prices of many of these companies have crashed by 70–90% within a year of going public. While one can always attribute the crash to broad market correction, I want to reason that it is a standard pattern rather than an anomaly. This is not to say that these business don’t have solid fundamentals or a bright future. It’s just that buying it on the day it goes public is not the best idea.

A list of few celebrated tech startups that went public in 2020 and 2021. You would have lost a fair bit of money if you bought their stocks on the day of IPO.

So why is investing in an IPO such a bad idea?

I want to share two main reasons for this. Understanding and registering them as mental models can help you make better investment decisions and save you a ton of money in the future.

Reason 1: It’s an unfair trade and you are on the losing end

Let’s take a step back and see what really happens when a company goes public.

The company would have been started 5–10 years back by a few co-founders who devoted every waking hour of their life and overcame extreme odds to get their startup to this place. They hired a group of very talented people who chose to forgo comfort in cushy jobs at large stable companies to toil along with founders for many years. The founders were backed by a number of Investors at different stages, ranging from Seed investors to VCs to private equity firms. The IPO is their payday, and they all waited for years for this moment. The higher the valuation of the company at IPO, the more money every single stakeholder — investors, founders, and employees — will make.

These are extremely smart folks who understand their business in and out. They know what’s the fair value of the company and what’s the maximum they can get. They even hire bunch of investment bankers to justify sky-high valuation, and then beef it up some more. They have the skills and every incentive to go public at the maximum possible valuation, even if it looks borderline insane.

And now think about where you stand in this transaction. You don’t understand the business as well as these folks. You don’t have any insider information about the prospects of the company. And you neither have the capability, time, or the interest to dig into the financials of the business or the industry it operates in. All you know is that you just like the product, have good things about the company, or are generally optimistic about the domain.

Think about the information asymmetry here.

Now remember the context that all of it’s likely happening at the peak of a bull run. The companies always choose such a time to go public. It’s Euphoria all around, there is a excitement in the air, and you have a fear of missing out because everyone around you is talking about IPOs. Everything sells in these conditions and everything can be justified, especially unreasonable valuations.

So to sum up, you come to the buying table to purchase shares of a company. On the other side of the table are extremely smart and sophisticated people who have all the information about the company, deep incentives to sell at maximum possible price, and the power to set the price. You on the other hand, are intoxicated by rising markets and barely know anything about the business you are buying shares of. The stakes are high. You are literally putting your financial future on the line with your hard earned money.

This is not a fair trade by any means.

The only option you have is to get up from the negotiation table and leave. And that’s exactly what you should do.

Reason 2: The opportunity to buy a good company isn’t going anywhere

You can make a counter-argument at this point that great companies like Amazon, Google, Netflix, and Meta have gone on to grow exponentially after their IPO. You would be right, but there are two things to consider here.

First, there is a bit of a selection bias at play. There are many companies that became public with a lot of fanfare, but delivered flat or no growth since then. Consider Dropbox, the once darling of the tech industry. Even after 4 years since its IPO in the 2018, it did not deliver any returns to investors. In fact, it lost about 25% value in this time period. Most stocks end up in this zone of value destruction. Companies like Amazon, Alphabet, and Meta and truly the exception.

Second, and more importantly, its vital to remember that a business is great because it stays great for a very long time. It proves itself over and over again with growing earnings and market domination. And the volatile market provides many opportunities to invest in at attractive valuations.

Take the example of Alphabet (Google). It went public in Aug 2004 at $2.71 per share based on today’s stock price (original price: $85). 5 years after it’s IPO, it was trading at about $11.5 per share. Today the stock trades at about $110 and has delivered a total return on 22% CAGR since going public. If you had invested in the stock in 2008, five years after it’s IPO, the price would have grown by 10x. Or to put it another way, 90% of growth in value started happening five years after the IPO. Alphabet, like Amazon, Apple, or Microsoft, proved itself over time. And the patient investors got multiple chances to buy the stock at a fair discount.

Alphabet’s stock price from Apr 2004 to Sep 2022. The stock traded at attractive valuations at many points after its IPO.

The same argument goes for more traditional companies. Warren Buffet invested in Coca Cola 70 years after it’s IPO, and still went onto benefit massively from stock’s growth.

And even if you feel that a company like Doordash or UIPath is going to be hugely valuable in future, 2022 is any day a better time to buy those stocks than a year back when they went public. You can now buy the same stock for 65–80% discount if you waited for some more time.

So what does this mean for the long-term investor?

The reason we rush to invest when a company goes public is because we don’t have the right mental models and we can’t manage our emotions when animal spirits run high. But if we stop to think about it, it’s not hard to reason why IPOs are perhaps a bad time to invest in a company. You have major asymmetries working against you, you are too influenced to make the right decision, and if you indeed want to buy the stock, there will be much better buying opportunities in near future if you wait just a little bit longer.

Let the company prove itself for some time and start trading at reasonable valuations. Then when the noise is filtered out and you have a clearer mind, chances are that you will take a much better decision.

“An IPO is like a negotiated transaction — the seller chooses when to come public — and it’s unlikely to be a time that’s favorable to you”

Warren Buffet

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