Three Red Flags for an IPO

Investing is a risky business — there is no guarantee of success, and in the worst case scenario, everything you’ve invested can be lost. Savvy investors try to mitigate this risk by learning as much as possible about the business they plan to invest in.

In the case of initial public offerings (IPOs), however, the amount of information available is significantly less than for longstanding public companies. Private companies do not have the same reporting requirements and usually do not get scrutinized as much as public companies do. In addition, a lot of the information provided during the IPO process comes directly from the horse’s mouth (i.e. from the company itself), making it less than one hundred percent objective. This makes investing in IPOs even riskier.

Still, there are a few warning signs that investors can look for when evaluating potential IPO investments. Below are my top three red flags:

1.  No clear strategy to reach profitability and positive cash flow

Companies planning to go public are not always profitable and often have negative cash flow. This is not necessarily a problem or a red flag in itself — often the goal of the IPO is to provide the financial resources to reach these goals. Amazon.com (NYSE: AMZ)(STG: AMZ) is a great example: It lost $3 million on $16 million in sales during its March quarter in 1997 when it was preparing to go public. Since than, it has turned into a giant with a $143 billion market cap and the share price has increased more than 200-fold compared to the initial IPO price.

Still, even a loss-making, cash-burning company needs to be able to clearly explain how it plans to become profitable and generate positive cash flow. Reading through the section of the IPO prospectus that contains the strategy and business outlook, potential investors can learn a great deal about the future prospects of the business. Naturally, this part of the prospectus needs to be read with a grain of salt — business outlooks are often painted a little too rosy in the prospectus — and it is worth it to validate the assumptions through external sources or compare them to those of other players from the industry.

If the company is not able to demonstrate a clear strategy to profitability and cash flow — as we saw during the Dotcom bubble in the late nineties — it should be a warning sign against investing in the business.

2.  IPO cash used to repay loans or buy the equity from existing owners

Ideally, you would want to see the money raised to go towards activities supporting the long-term corporate strategy, for example, product research or geographical expansion. These are the types of activities that should generate return on the money invested in the company.

On the other hand, if the planned usage is to repay existing loans, that could mean that the company is unable to honor its debt obligations without issuing stock, which would cast a shadow of doubt over the financial management of the company.

If the proceeds are used to buy shares from existing owners, it means that current shareholders — who have much more inside knowledge about the company than retail investors — are using the IPO as an exit strategy and want to sell or reduce their stake in the company. This doesn’t inspire too much confidence in the future prospects of the business.

If the company states “general corporate purposes” as intended use for the IPO money, it can also raise some serious concerns. This either implies that the company hasn’t clearly identified yet what it plans to do with the money (in which case one could question the strategic leadership of the company), or that it is burning cash and it needs the proceeds for daily operations as opposed to strategic purposes.

Consider the following examples of intended use of IPO proceeds:

1. “The Issuer currently intends to spend approximately €400 million to €500 million (…) on investments in proven winners in order to increase its stakes in these companies (…) €250 million to €350 million on equity capital investments in selected emerging stars (…) in order to retain or attain a majority position over the long-term (…) [and] €600 million to €700 million on concepts and new companies in order to (…) retain a majority ownership position also over the long-term.” – Rocket Internet (ETR: RKET) IPO Prospectus
2. “We have not yet determined any specific use of the proceeds of this Offering. The Company intends to use the net proceeds from this Offering to fund the continued long-term growth of the Company, as well as for general corporate purposes. (…) such use might include (…) the geographical expansion of our existing business, as well as the expansion into new or related lines of business and selective acquisitions, in each case in furtherance of our corporate strategy.” – Zalando (ETR: ZAL) IPO Prospectus
3. According to the Wall Street Journal Deutschland, German Internet portal Scout24 expected to announce its IPO plans on Oct 9 (the announcement got delayed due to overall market sentiment). The company plans to offer 25% of the existing shares for sale, with both major owners Hellman & Friedman and Deutsche Telekom (ETR: DTE) planning to reduce their stakes.

From the above three examples, Rocket Internet has given the most details about the use of the IPO proceeds, and this use is also very much in line with its strategic goal of strengthening its ownership stake in Rocket’s various operating companies. Zalando’s prospectus is much less clear about the intended use of the IPO money, and – based on the initial reports – it sounds like the owners of Scout24 would like to have less of their money tied to the Internet portal – why would you want to have more of yours?

3.  Stock aggressively pushed or offer price reduced during IPO process

Getting shares of a hot IPO is difficult for the average retail investor. This is because the underwriters (i.e. the investment banks responsible for organizing the IPO) don’t have small investors as their target markets. They focus on courting the big institutional investors. If you have an account with one of the banks involved in the underwriting, they may be willing to allocate you shares at the IPO price — assuming you are a frequently-trading client with a large enough account. Put differently: Most people who wanted to get in on the Alibaba (NYSE: BABA) IPO couldn’t get shares at the $68 initial price, and instead had to buy it on the first day of open trading for more than $90.

Therefore, if your broker approaches you with a hot IPO tip, it is good to be extra cautious. This usually indicates that the underwriter couldn’t sell the shares to the big institutional investors — so you may be getting shares that nobody else wants. To paraphrase Groucho Marx: I don’t care to own shares in any IPO that wants me as a shareholder.

Another sign of trouble is if the offer price is being reduced during the underwriting process. This could also indicate that there is not enough demand for the company’s shares.

The underwriter itself can also be an indication of the quality of the company. Big investment banks can be pickier about their clients, while a smaller brokerage may be willing to underwrite any company, including bad ones (this, of course, doesn’t mean that big banks only underwrite good companies).

In other words: If a small, little-known brokerage is aggressively pushing an IPO, it may be best to run the other way.

Closing thoughts

The above points are obviously not carved in stone. A clear strategy doesn’t necessarily mean success, the use of proceeds doesn’t determine the fate of the company, and you may get lucky with a hot IPO tip from the neighborhood bank.  Again, Amazon.com serves as a good example: In its IPO prospectus, the company highlighted the risk of “substantial operating losses for the foreseeable future”, and planned to use the proceeds for “general corporate purposes, including working capital to fund anticipated operating losses and capital expenditures”.

Also, there are many other things to consider — for example company financials and valuation, industry dynamics, company growth prospects — before making an investing decision.

However, keeping in mind the above red flags should help you better identify potential risks with an IPO investment idea.